SUBJECT: Michigan Department of Management and Budget

DECISION

The Michigan Department of Management and Budget (Michigan) appealed the decision of the Division of Cost Allocation (DCA) requiring repayment of $108,756 in federal funding that Michigan held as reserves in a fund used to provide information technology and related services and goods to Michigan state agencies, some of which administer federally-funded programs. DCA determined that the amount represented the federal share of the fund's reserves that exceeded the level permitted by applicable cost principles.

Michigan did not dispute the determination that the reserve exceeded the allowable level, or the amount of the federal share of the excess. Instead, Michigan challenged DCA's determination that Michigan must refund the federal share of the excess, rather than attempt to reduce the excess by lowering charges to federal funds in future years. As explained below, we conclude that DCA presented reasons for requiring a refund of the unallowable amount that are fully supported by the record, and are consistent both with the applicable criteria for determining the method of recoupment of such overpayments and with DCA practice.⁽¹⁾ Accordingly, we uphold DCA's determination.

Applicable cost principles

The allowability of costs claimed by state governments under federal grants is governed by Office of Management and Budget (OMB) Circular A-87. 45 C.F.R. §§ 74.27(a) and 92.22(b). In order to be allowable, a cost must be necessary and reasonable for proper and efficient performance and administration of a federal award and allocable to the award. OMB Circular A-87, Attachment (Att.) A, ¶ C.1. A cost is allocable to a particular cost objective if the goods or services involved are chargeable or assignable to such cost objective in accordance with relative benefits received. OMB Circular A-87, Att. A, ¶ C.3.a.

This dispute concerns the mechanism that Michigan uses to claim central service costs from the federal government. Central service costs are the costs of services provided by a state on a centralized basis to its various departments and agencies, which in turn may receive federal funding in those costs, to the extent they administer federally-funded programs. Central service costs typically include computer services, transportation services, insurance, fringe benefits, general accounting, personnel administration and purchasing. Central service costs are either billed to benefitting agencies and programs on an individual fee-for-service or similar basis (billed central service costs), or allocated to the agencies and programs on some other reasonable basis (allocated central service costs). OMB Circular A-87, Att. C, ¶¶ A.1, B.1, B.2.

To identify central service costs and assign them to benefitting activities on a reasonable and consistent basis, OMB Circular A-87 establishes a process known as the central service (or statewide) cost allocation plan. OMB Circular A-87, Att. C, ¶ A.1. The cost allocation plan describes the method by which the costs will be distributed to different programs, as well as all costs and other data used to distribute the costs included in the plan. Id. For each year that a state claims central service costs, it must submit a cost allocation plan for review, negotiation and approval by the cognizant federal agency. OMB Circular A-87, Att. C., ¶¶ D.1, F.1. The Department of Health and Human Services has been designated as the cognizant federal agency for the Michigan Department of Management and Budget. 51 Fed. Reg. 552 (1986). DCA has the responsibility for negotiating cost allocation plans with states and, where agreement cannot be reached, for issuing initial determinations that then may be appealed to this Board under 45 C.F.R. Part 16.

The requirements for cost allocation plans are listed in OMB Circular A-87, and in an implementation guide issued by this Department pursuant to OMB Circular A-87, "A Guide for State and Local Government Agencies: Cost Principles and Procedures for Establishing Cost Allocation Plans and Indirect Cost Rates for Agreements with the Federal Government" (ASMB-10). OMB Circular A-87, Att. C, ¶ A.2.

The monies that a state collects from its agencies through billings for centralized services and goods are typically deposited into an "internal service fund" (ISF), which the state uses to finance those services and goods. Because ISFs are typically funded through periodic billing cycles, the cost principles permit them to maintain a working capital reserve to enable payment of expenses as they arise. OMB Circular A-87 permits an ISF to maintain a working capital reserve as part of its retained earnings sufficient to cover up to 60 days cash expenses for normal operating purposes:

Working capital reserves. Internal service funds are dependent upon a reasonable level of working capital reserve to operate from one billing cycle to the next. Charges by an internal service activity to provide for the establishment and maintenance of a reasonable level of working capital reserve, in addition to the full recovery of costs, are allowable. A working capital reserve as part of retained earnings of up to 60 days cash expenses for normal operating purposes is considered reasonable. A working capital reserve exceeding 60 days may be approved by the cognizant Federal Agency in exceptional cases.

OMB Circular A-87, Att. C, ¶ G.2.

When the revenue collected for billed central costs exceeds the allowable costs of providing the services and goods (including an amount sufficient to maintain an ISF reserve of up to 60 days cash expenses for normal operating purposes), an adjustment must be made for the difference, so that federally-funded programs are not overcharged. OMB Circular A-87, Att. C., ¶ G.4. The adjustment is made by one of the following methods:

(a) a cash refund to the Federal Government for the Federal share of the adjustment, (b) credits to the amounts charged to the individual programs, (c) adjustment to future billing rates, or (d) adjustments to allocated central service costs. Adjustments to allocated central services will not be permitted where the total amount of the adjustment for a particular service (Federal share and non-Federal share) exceeds $500,000.

OMB Circular A-87, Att. C., ¶ G.4.

ASMB C-10 provides criteria for selecting the method of recovery:

The primary concern would be the assurance that the Federal programs charged in a given year receive an equitable and appropriate adjustment for the over/under billings. Consideration must also be given to the makeup of the user community in future periods as well as the level of support they will require.

ASMB C-10, § 4.8, Question 4-14.

Michigan uses the ISF at issue here, the Master Contract ISF, to purchase computing and other information technology products and services for use by all state executive branch agencies. Michigan did not dispute that the Master Contract ISF had excess reserves of $531,035 at the end of fiscal year (FY) 2000, or that 20.48% of the excess, $108,756, consisted of federal funds, a figure that Michigan determined and reported to DCA. DCA Exhibit (Ex.) 3. Michigan also did not argue that it should be permitted to maintain a reserve exceeding 60 days normal operating expenses, which DCA may approve only in "exceptional cases." OMB Circular A-87, Att. C, ¶ G.2.

Instead, Michigan challenged DCA's determination to seek a refund of the federal share, arguing that it should be permitted to pay back the excess by reducing future billing rates for the services funded through the Master Contract ISF, one of the three applicable alternatives for recovering excess reserves listed in OMB Circular A-87. OMB Circular A-87, Att. C., ¶ G.4. Michigan argued that it had elected to diminish the excess reserve by reducing Master Contract charges. Michigan noted that, in past years, the Master Contract ISF had included contracts with companies such as Lotus, Banyan, Oracle, Netscape, Groupwise, and DSN, but that, for FYs 1999 and 2000, the ISF eliminated charges for all but one contract, with EDS, for the purchase of miscellaneous equipment such as PCs, monitors, keyboards, cables, etc.; this contract totaled $602,992 in FY 2000. Michigan Brief (Br.) at 1-2. Michigan reported that it planned to eliminate all Master Contract charges, and, after the reserve was eliminated, to fund Master Contract services from appropriations. Michigan argued that the reduction and elimination of its Master Contract rates would likely not shift costs among programs, because of what Michigan described as the statewide, routine, repetitive nature of the Master Contract purchases by its various state agencies, and the absence of significant variation in the Master Contract customer base from year to year.

As noted above, ASMB C-10 provides that the method selected to recover the federal share of excess revenues for billed central service costs must assure that the federal programs charged in a given year receive an equitable and appropriate adjustment for the over billings. For the reasons explained below, we agree with DCA that the repayment method it selected provides the requisite assurance that federal programs will receive an equitable and appropriate adjustment for the over billings that funded the excess reserve, and that the alternative method sought by Michigan would not.

An important consideration supporting DCA's determination was the undisputed fact that the excess reserve increased considerably, despite Michigan's effort to reduce it. The excess grew from $415,907 at the end of FY 1999 to $531,035 at the end of FY 2000. DCA Br. at 10; Michigan Br. at 2. These amounts substantially exceeded the permissible reserve level under OMB Circular A-87.⁽²⁾ The increase in the excess reserve occurred despite the fact that total revenue was decreasing. See Michigan Ex. D. These substantial surpluses could have accumulated only from Michigan using a billing rate that considerably overstated the cost of providing services to state agencies, and the federally-funded programs they administer. The surpluses thus resulted from unallowable charges to federal grants, by which Michigan received federal funds to which it was not entitled. Moreover, DCA reported that although Michigan asserted in April 2001 that the excess reserve in its Master Contract ISF would be eliminated by the end of FY 2001, there was still an excess at the close of that fiscal year; in its brief Michigan acknowledged a projected balance of over $140,000. DCA Br. at 13; Michigan Br. at 2.

DCA's requesting a refund is consistent with its practice where an excess reserve is large and increases from one year to the next. An affidavit from DCA's branch chief for state and local governments indicates that DCA will typically not request a refund of the federal share of an excessive ISF reserve where subsequent fiscal data, if available, shows that the excess disappeared in the following fiscal year. DCA Ex. 10. If the excess is not entirely eliminated but remains small, DCA may continue to monitor the reserve to see if it disappears in the year after that. Id. DCA apparently thus declined to seek refunds from two other Michigan ISFs which reported excess reserves at the end of FY 1999: in one ISF the excess reserve was eliminated in the following year, and in the other the excess was reduced and the federal share was approximately $31,000. DCA Ex. 1. However, where, as here, an excess reserve balance increases in a subsequent fiscal year, DCA will demand a refund of the federal share. DCA Ex. 10. This practice makes sense since it evaluates whether permitting adjustments in future years will protect the federal interest based in part on past performance by the ISF.

ASMB C-10 also provides that consideration must be given to the makeup of the user community in future periods as well as the level of support they will require. DCA relied on the fact that Michigan's records for FYs 1999 to 2000 disclosed variations in the extent to which different state agencies utilized Master Contract services. As DCA noted, those records show, for example, that a state agency or office identified as MESC incurred 5.6% of the total charges for the EDS contract during FY 1999, but 9.6% in FY 2000, and that another, FIA, incurred 19.3% of total EDS contract charges during FY 1999, and 24.6% during FY 2000. Michigan Ex. D. Since Michigan state agencies administer a variety of federal and state programs, such variations may reflect variations in the extent to which those programs purchase Master Contract services. Those federal programs that utilize fewer Master Contract services during a period of rate reduction than they did in prior periods would, in effect, be paying the costs of those programs whose usage increases during that time. Michigan's argument that usage patterns would likely not vary between FY 2000 and 2001 did not address the specific data noted by DCA, comparing FY 1999 and FY 2000. Yet, most of the excess accumulated prior to FY 2000, and the ISF revenue in those years was derived from contracts in addition to the EDS contract. Percentages of total revenue were not necessarily the same as the percentages attributable only to the EDS contract. See Michigan Ex. D.

Michigan noted that DCA's determination letter rejected Michigan's proposal to reduce the Master Contract billing rates on the grounds that this method would shift current costs to earlier years, in violation of OMB Circular A-87's prohibition on shifting costs among federal awards, for any reason. OMB Circular A-87, Att. A, ¶ C.3.c. Michigan argued that OMB Circular A-87 effectively authorizes cost-shifting among different years by listing "adjustment to future billing rates" as a possible method to account for excess revenues from central service costs. OMB Circular A-87, Att. C., ¶ G.4. However, DCA did not pursue this basis for its determination before the Board. Instead, DCA argued that abating the excess reserve through a rate reduction instead of a refund under the circumstances here would shift costs among different federal funding programs, which is clearly prohibited by OMB Circular A-87.

We further note that Michigan's proposal was to reduce the billing rate to zero for FY 2001 and subsequent years, as necessary. DCA explained that this would make it administratively burdensome for DCA to monitor the reserve, and interest earned on the reserve. Michigan did not dispute this point.

Thus, the record supports DCA's determination that Michigan must refund the federal share of the Master Contract ISF excess reserve, and that Michigan's proposal to reduce its Master Contract billing rates failed to assure that federal programs would be appropriately and equitably compensated for the over billings.

Conclusion

For the reasons discussed above, we sustain DCA's decision requiring repayment of the excess reserve funds.

Donald F. Garrett

M. Terry Johnson

Judith A. Ballard
Presiding Board Member

1. DCA's determination also required refund of an additional $73,891.58, representing the federal share of excess reserves in a different fund. During Board proceedings, Michigan withdrew its appeal of that part of the determination.

2. DCA said that the reserve at the end of FY 2000 was six times the allowable amount. DCA did not explain how it calculated this ratio, but Michigan did not dispute it. Michigan reported total retained earnings at the end of FY 2000 of $565,364 in its Exhibit C, but did not dispute the DCA finding that $531,035 of that was excess (leaving $34,329 as non-excess). This suggests that the reserve may have been much more than six times the allowable amount.