A Fortune 500 defense contractor learned the hard way that misallocating material costs can trigger a $47 million cost adjustment under CAS 418. Their error? Using headcount to allocate material handling costs when square footage was the appropriate allocation base. The Defense Contract Audit Agency (DCAA) didn’t just reject their methodology—they demanded repayment of previously accepted costs spanning four contract years, plus interest calculated under 10 USC 2324(c).

This isn’t an isolated incident. Material cost allocation violations under Cost Accounting Standards (CAS) 418 represent one of the most frequent and expensive compliance failures in federal contracting. When contractors guess at allocation methodologies rather than following CAS 418’s strict causal-beneficial relationship requirements, they face cost adjustments, contract suspensions, and permanent damage to their accounting system adequacy.

Legal Foundation: The Regulatory Framework That Controls Material Costs

CAS 418, codified at 48 CFR 9904.418, establishes the mandatory standards for allocating direct and indirect costs. The regulation requires that “the allocation of indirect costs shall be based upon a causal or beneficial relationship between the indirect cost and cost objectives.” This isn’t a suggestion—it’s a legal requirement that carries the full force of federal law under 41 USC 1502.

Federal Acquisition Regulation (FAR) 30.202-1 makes CAS compliance a contract requirement, stating that covered contracts “shall contain a clause requiring compliance with all CAS in effect on the date of contract award.” Violations don’t just affect future costs; they trigger retroactive adjustments under FAR 30.606, which can span multiple contract years and include compound interest calculations.

The Defense Contract Management Agency (DCMA) reinforces these requirements through its Contract Management Manual, which specifically addresses material cost allocation as a high-risk audit area. When DCAA auditors find CAS 418 violations, they’re required to quantify the cost impact and recommend contract adjustments under the authority granted by 10 USC 2313.

Common Violation Patterns: Where Contractors Fail CAS 418 Compliance

The Convenience Allocation Trap: Contractors routinely allocate material handling costs based on whatever data they have readily available—usually headcount or direct labor dollars. A major aerospace contractor allocated $23 million in material handling costs using direct labor ratios, despite clear evidence that square footage of production space drove these costs. DCAA’s cost adjustment exceeded $8 million.

The Historical Precedent Fallacy: Companies assume that previously accepted allocation methods remain compliant indefinitely. A shipbuilding contractor continued using headcount allocation for material storage costs for six years after expanding their facility footprint by 300%. The changed circumstances invalidated their allocation base under CAS 418-50(a), resulting in a $12 million cost adjustment.

The Single Allocation Base Error: Contractors often force all material-related costs into one allocation base when multiple bases would better reflect the causal-beneficial relationship. Material procurement costs may correlate with purchase volume, while material handling costs correlate with storage space, and material inspection costs correlate with the number of receipts.

The Documentation Deficiency: Even when contractors use appropriate allocation bases, they fail to document the causal-beneficial relationship as required by CAS 418-40. DCAA consistently rejects allocation methods that lack supporting analysis, regardless of their theoretical appropriateness.

Step-by-Step CAS 418 Compliance Requirements

Step 1: Conduct Causal-Beneficial Analysis Document the specific causal or beneficial relationship between each material cost pool and potential allocation bases. This analysis must be in writing and updated whenever circumstances change materially. The analysis should identify the activity that drives the cost and measure how cost objectives benefit from that activity.

Step 2: Establish Homogeneous Cost Pools Group material costs that have similar allocation relationships under CAS 418-50(b). Material procurement costs, material handling costs, and material quality assurance costs typically require separate pools because they have different causal relationships with cost objectives.

Step 3: Select Allocation Bases with Measurable Relationships Choose allocation bases that can be measured objectively and correlate with the incurrence of costs. Square footage works for storage costs, number of transactions works for procurement costs, and weight or volume may work for shipping costs. The base must be measurable for all cost objectives receiving allocations.

Step 4: Document Allocation Base Changes Any change in allocation methodology requires advance disclosure under CAS 418-64 and FAR 30.601. The contractor must demonstrate that the new method better reflects the causal-beneficial relationship and quantify the cost impact of the change.

Step 5: Implement Consistent Application Apply the selected allocation methods consistently across all cost objectives and time periods under CAS 418-60(a). Selective application of allocation methods based on contract type or customer constitutes a CAS violation subject to cost adjustment.

Cost of Non-Compliance vs. Cost of Compliance

Non-compliance with CAS 418 carries severe financial consequences that extend far beyond simple cost adjustments. The immediate cost includes retroactive adjustment of previously submitted costs, calculated with compound interest under FAR 30.606(a)(3). A medium-sized defense contractor faced a $31 million cost adjustment that included $4.7 million in interest charges accumulated over three audit years.

Contract suspensions represent another significant cost. When DCAA determines that a contractor’s accounting system is inadequate due to CAS violations, DCMA can suspend progress payments under FAR 32.503-6. One electronics manufacturer lost access to $127 million in progress payments for eight months while correcting CAS 418 allocation deficiencies.

The cost of compliance, by contrast, involves primarily documentation and system modifications. Establishing proper cost pools typically requires 40-60 hours of accounting system analysis. Implementing new allocation bases may require software modifications costing $15,000-$50,000 depending on system complexity. Annual maintenance of CAS compliance typically costs $25,000-$75,000 for mid-sized contractors.

Compliance also provides competitive advantages. Contractors with adequate accounting systems can bid on larger contracts and receive more favorable payment terms. DCMA’s accounting system approval process specifically evaluates CAS 418 compliance as a threshold requirement for major defense contracts.

Multi-State and Federal Jurisdiction Requirements

CAS 418 requirements apply uniformly across all federal agencies and geographic locations. A contractor performing work in multiple states must apply the same allocation methodologies consistently, regardless of local business practices or state regulations. The Federal Circuit has consistently held that CAS requirements preempt state law under the Supremacy Clause.

Interstate contractors face additional complexity when allocating shared material costs across multiple facilities. CAS 418-50(c) requires that allocation methods recognize all significant causal factors, including geographic cost differences and facility-specific activities. A contractor with facilities in California, Texas, and Virginia must document how material costs relate to activities at each location.

Federal agencies coordinate CAS compliance through the CAS Board’s interpretations and the Federal Acquisition Security Council’s guidance. When one agency identifies CAS violations, that information is shared through the Federal Awardee Performance and Integrity Information System (FAPIIS), potentially affecting the contractor’s ability to win contracts with other agencies.

The Defense Contract Audit Agency maintains regional offices that apply CAS 418 requirements consistently across their audit territories. However, contractors should note that local DCAA offices may emphasize different aspects of compliance based on regional audit findings and emerging compliance patterns.