Why government contract manufacturing is different from commercial manufacturing

Commercial and government contract manufacturers may use similar equipment, talent and suppliers, but the regulatory expectations are fundamentally different. As more manufacturers pursue opportunities in defense, aerospace, energy and critical infrastructure, executives often underestimate how significantly their operating model must change when they begin performing on government contracts. 

The National Defense Authorization Act for Fiscal Year 2026 (FY26 NDAA or NDAA) provides meaningful relief for commercial manufacturers by expanding nontraditional defense contractor (NDC) status, but the core compliance expectations for cost accounting, business systems, supply-chain controls, cybersecurity and audit readiness remain intact.

What changed?

The new NDAA significantly reduces the barrier for commercial manufacturers entering the government contract space by exempting qualifying companies from several requirements, including the following:

• Federal Acquisition Regulation (FAR) Part 31 cost principles
• Defense Federal Acquisition Regulation Supplement (DFARS) business systems requirements
• Certified cost or pricing data requirements under the Truthful Cost or Pricing Data statute (TCPD)

What did not change 

The new NDAA significantly reduces the barrier for commercial manufacturers entering the government contract space by exempting qualifying companies from several requirements, including the following:

• Federal Acquisition Regulation (FAR) Part 31 cost principles
• Defense Federal Acquisition Regulation Supplement (DFARS) business systems requirements
• Certified cost or pricing data requirements under the Truthful Cost or Pricing Data statute (TCPD)

The new NDAA significantly reduces the barrier for commercial manufacturers entering the government contract space by exempting qualifying companies from several requirements, including the following:

• Federal Acquisition Regulation (FAR) Part 31 cost principles
• Defense Federal Acquisition Regulation Supplement (DFARS) business systems requirements
• Certified cost or pricing data requirements under the Truthful Cost or Pricing Data statute (TCPD)

What did not change 

Expanded NDC flexibilities do not make their status permanent. NDC status does not shield a manufacturer from becoming a traditional defense contractor once certain Cost Accounting Standards (CAS) thresholds are met. Here are the details:

• Modified CAS (equal to or more than $35 million)
  A nonexempt negotiated award that is $35 million or more immediately becomes modified CAS-covered, requiring compliance with: 
  • CAS 401: Consistency in Estimating, Accumulating and Reporting Cost
  • CAS 402: Consistency in Allocating Costs Incurred for the Same Purpose
  • CAS 405: Accounting for Unallowable Costs
  • CAS 406: Cost Accounting Period

When this occurs, the contractor must accumulate costs at the contract or contract line item number (CLIN) level and exclude unallowable costs in proposals and billings, even though it retains NDC status.

• Full CAS (equal to or more than $100 million)
  A business unit becomes subject to full CAS once it receives $100 million or more in CAS-covered awards during the prior cost accounting period. When this happens, NDC status ends, and the company is now a traditional defense contractor subject to:
  • Full CAS requirements
  • All six DFARS business systems requirements
  • TCPD statute requirements above $10 million
  • Full FAR and DFARS compliance

Additional ways NDC status can be lost

Contractors often lose NDC status when they perform cost-type research and development (R&D), development work or noncommercial production orders that trigger cost-based oversight and CAS coverage. NDC eligibility also ends when a merger, acquisition or internal realignment places the contractor within a CAS-covered segment.

While the FY26 NDAA may lower some barriers to entering defense contracts, negotiated awards still require CAS-compliant cost accumulation, and growth in government awards can quickly push contractors into full CAS compliance. Manufacturers need compliant systems, processes and controls in place before they scale. Leaders should consider the following:

Most commercial manufacturers underestimate the level of operational visibility required by government contracting. Before accepting government contracts, commercial chief finance officers must develop a clear and detailed understanding of the manufacturing workflow and government requirements. Government contract compliance depends on traceable, defensible and repeatable processes. This means going beyond enterprise resource planning (ERP) and seeing what actually happens on the shop floor, including the following:

• How does material move from receiving through work in progress (WIP) and into finished goods? Leaders should understand how components are staged, kitted, issued, consumed, transferred and completed. Government work requires traceability, and auditors will expect contractors to explain how material was used/consumed on each job/project.
• How is labor captured and applied? Timekeeping is one of the highest-risk areas for new government contractors. They must identify where direct labor begins and ends at each step of the process, and whether labor should be captured through timecards, work center reporting, barcode scanning or operation-level confirmations.
• Where do scrap, rework, downtime and yield loss occur? Commercial operations often bury these variances in overhead. Government contracting does not allow that. Contractors must know where losses occur, how they are recorded and how they affect material and labor requirements on a job-by-job basis.
• Which activities drive costs? Identify the real cost drivers: people, machines, setups, inspections, engineering support, tooling and/or changeovers. Government contracting requires costs to be allocable, allowable, and reasonable, which means there must be a defensible basis for applying indirect costs.

Government contractors need a framework that supports allowability, allocability, consistency and audit readiness as they scale beyond NDC flexibilities and into CAS-covered contracts. Leaders should focus on:

• Contract-type strategy (i.e., firm fixed price versus cost-type)
• Documentation that ties costs to contract, CLINs and production orders for full traceability
• Reporting discipline for timely operational and contractual reporting
• Clear segregation of direct and indirect costs and the redesign of the chart of accounts
• Indirect rate structures that reflect causal-beneficial relationships
• Controls that identify and exclude unallowable costs in accordance with FAR Part 31
• Forward pricing practices, indirect rate development and incurred cost support enabling defensible cost proposals, negotiation readiness and audit traceability

Government contracting requires contractors to select the costing methodology that reflects operational reality and provides the meaningful cost visibility required under federal cost principles. These methodologies include the following:

• Standard costing (requires disciplined bill of materials (BOMs)/routings and variance control)
• Actual costing (best for high-complexity, cost-type, R&D and prototype)
• Hybrid models (common in mixed commercial/government contracting shops)
• Project/job costing (accumulation by contact/CLIN required, which is necessary for cost-type work)
• First in, first out/last in, first out /average costing (used for inventory valuation)

A common ERP pitfall is poor visibility into the cost elements that accumulate into WIP. Government contractors must maintain clear operational-level visibility into the cost elements (e.g., direct labor, direct materials and applied overhead) included in WIP. That visibility is essential for calculating accurate annual indirect rates and complying with FAR 31.201-2, which requires that costs claimed or allocated to government contracts be properly supportable, allowable and allocable. 

Commercial manufacturers migrating to government contract manufacturing need to understand the cybersecurity and supply chain requirements that do not apply to their commercial business. These include the following:  

• Controlled unclassified information (CUI)/ Cybersecurity Maturity Module Certification (CMMC). Manufacturers must ensure the required CMMC level aligns with contract eligibility and that their cybersecurity controls comply with NIST SP 800-171. This means knowing exactly:
  • Who can access CUI
  • How data is stored, transmitted and processed
  • How data is secured across systems, networks, cloud environments and facilities
  • How cyber incidents will be reported under DFARS requirements
  • Whether requirements have flowed down to the subcontractor level?
• Counterfeit-parts prevention (DFARS 252.246-7007 and -7008). Department of Defense (DoD) contracts require a documented system for preventing, detecting and reporting counterfeit electronic and mechanical parts. This includes:
  • Supplier vetting and approval
  • Traceability to original manufacturers
  • Inspection, testing and material authentication
  • Reporting through the Government Industry Data Exchange Program (GIDEP) when suspected or confirmed counterfeit parts are identified
• Domestic sourcing and supplier compliance. The Buy American Act (BAA) and DFARS Part 225 domestic-content rules are the governing structures for most DoD manufacturing. These rules require manufacturers to track material origin, verify U.S./qualifying-country content and ensure that suppliers meet specialty-metal, component and end-product requirements. Failure to document this at the bill of materials (BOM) and supplier level is a common compliance gap.