Indirect Costs Explained/DCAA Compliance

The subject Indirect Costs is one of the most complex and high profile items in managing government contracts. It is one of the most misunderstood items as well.  It is a high profile item for regulatory agencies such as DCAA for sure.  To be successful contractors need to get a good handle on managing indirect costs.  Below I outline the requirements and hopefully offer a simpler understanding for small businesses and large businesses alike.

This is mainly written for small business application but large businesses may benefit as well.   Also I have included some illustrations for small business indirect cost rate calculations.  Large companies subject to the cost accounting standards have additional requirements to consider.  The sections are listed below for direct access.   A discussion of indirect costs follows:

       I. Direct vs. Indirect Costing

      II. Indirect Cost Pools

     III. Allocation Bases

     IV. Intermediate Indirect Cost Pools

     V. Large Business Considerations (CAS 403, 410 and 418)

    VI. Indirect Cost Rate Calculations

I. Direct vs. Indirect Costing

The first item that must be mastered is to be clear on the definition of direct cost and indirect cost. Once defined the contractor must consistently code these costs direct and indirect.  Keep in mind contractor definitions and accounting practices drive direct vs. indirect, not government officials.  A direct cost is any cost that is identifiable to one and only one cost objective.  It normally is required or necessary for contract performance.  The term cost objective is a regulatory term that can include a contract, a project, a task, a contract line item.  It also includes individual indirect projects such as bid and proposal or an independent research and development project.  A common example of a direct cost is a material or equipment item purchased exclusively for one cost objective.  Or the time spent by an employee working on one cost objective.  Indirect costs are all costs that are not identifiable or incurred for the benefit of one cost objective.  A good example is a manager who oversees many contracts where it would be difficult to identify his/her time to each project.  Another is an equipment item that is used on multiple projects but would be difficult to split the costs between projects.  These costs are charged to indirect cost accounts.

Once these definitions are defined by the contractor then it is a matter of consistently coding or charging costs to either direct to cost objectives or to indirect accounts.  This consistency is crucial.  Failure to meet this consistency principle is a guaranteed failure and problems with DCAA.  Also it will distort your indirect rates as well. 

II. Indirect Cost Pools

Once the direct and indirect cost definitions are defined, the contractor must develop or maintain what the government calls homogenous indirect cost pools.  Homogenous means the indirect costs are grouped in logical groupings of accounts that have a similar relationship to the base being managed.  For example, it would be inappropriate to combine indirect costs related to a services business or cost center with a construction type business or segment.  It would be inappropriate to combine engineering support costs with support costs for production activities in a manufacturing setting.  It would also be inappropriate to combine operational costs with G&A type expenses.  The official definition by the CAS Board in its Statement of Objectives, Policies and Concepts is:

"Homogeneity means that the costs of functions allocated by a single  base have the same or similar relationship to the cost objectives for which the functions are performed, and the grouping of such costs in homogenous pools for allocation to benefitted cost objectives results in a better identification of costs with cost objectives."

To be compliant contractors must accumulate costs into homogenous indirect cost pools.  The typical framework is to have three indirect cost pools.  One for Fringe cost, one for Overhead and one for G&A.  This is the typical set up.  However most small businesses can get by was just two, Fringe and G&A as most small businesses will struggle to define costs into an overhead pool.  This may require splitting hairs to separate costs between Overhead and G&A.  In these cases, having just two pools is sufficient.  The structure all depends on the business structure and processes. 

To help determine what the proper structure should be I think it would be helpful to understand the definition of these cost pool types.

Fringe costs are rather straight forward.  It includes employee related costs including payroll taxes, fringe benefits such as health insurance and compensated absences (vacation, holiday and sick time). 

Overhead is defined as those indirect support costs incurred to support operations or direct production.  These are costs directly related to projects but cannot be identified to one project or contract.  A good example is operations management where functions support the overall operation.  Another is depreciation of equipment used on projects but not exclusively identifiable to one.  Quality assurance is another.  Supplies used or consumed in a process but not identifiable to one project or contract.  In summary it is related to the operation or production but not identifiable to one project, contract, order or product.

General and Administrative expense ( commonly referred to as G&A) are those expenses incurred for the overall operation or running of the business.  They are not identifiable to a project, contract, order or product.  They are not identifiable to operations or production.  They are necessary expenses to run or manage the business as a whole.  These expenses typically include the functions of executive, accounting and finance, IT, human resources, business development, marketing and sales.

Today most businesses combine G&A costs into one pool.  However, historically speaking and the technically correct approach is to have multiple G&A pools.  When I was a DCAA auditor this was the case especially for large businesses.  Typically there was a pool for administration, one for sales and one for IR&D/B&P.  However, since these pools are typically allocated on the same allocation base, it is acceptable to combine them.  I do recommend, especially in light of recent re-emphasis by DCAA on the marketing costs, that contractors at least create separate accumulations where sales and marketing costs are accumulated separately to fulfill DCAA requests to evaluate marketing costs separate from administration.  This can be accomplished by use of G&A departments or separate indirect cost pools.  However this only makes sense in organizations where there are significant sales and marketing costs.  It does not make a whole lot of sense if the sales and marketing costs are insignificant.  In considering all this, I recommend that departments or in very small businesses accounts be created to accumulate marketing costs separately.

The last pool to be considered is the unallowable cost pool.  Most do not consider this an indirect cost pool, but by definition it is an important cost pool.  This cost pool is required to accumulate and segregate costs deemed to be unallowable by FAR 31.2.  Contractors should set up cost accounts for each type of unallowable cost (See my discussion on Unallowable Costs for details on these costs).  Most contractors usually have one pool for unallowable costs.  However, as a contractor if you have unallowable direct costs and unallowable overhead costs, you may need to maintain a number of unallowable cost pools.  One for each indirect cost pool, mainly overhead.  This is necessary to fulfill the requirement to include unallowable overhead costs in the G&A allocation base.   This only applies if you have unallowable costs in any of the overhead pools or unallowable direct costs.  In any event, unallowable costs must be separately accumulated and excluded from any calculation of indirect cost rates either on a prospective or actual basis.

III. Allocation Bases

This subject is highly subjective and subject to great debate within the industry between contractors and the government.  It is a highly contentious issue.  My advice is to select a base that makes sense and one that is common in your industry.  Also it is a good idea to get DCAA buy-in to the indirect cost pools and allocation bases to hopefully avoid any problems.

The requirement is to allocate indirect costs in an equitable manner.  For contactors subject to the CAS, allocation bases to some degree are defined with added restrictions.  For the small business please consider the following discussion.

The proper allocation base is one that is directly related or causes the indirect costs to be incurred.  It can be an input measure or an output measure.  This has been the general theory for many years dating back to the Vietnam Era.  This idea is fine for variable indirect costs.  However, the face of the government contracting industry has changed dramatically and that theory just is not very workable.  Today fixed costs represent a very large component of indirect costs so an activity base does work well.  In any event, another criteria that has been in place for many years is that the allocation base selected must be the base that represents the total activity of the business or the cost pool to be allocated.  DCAA stands firm on this position.  So for this reason the old theories although not very applicable today are in full force.  Contractors must abide by these rules.

Theory is all fine and good but practical application and what the government considers proper drives this business.  So the widely accepted allocation bases are as follows:

Fringe: Total employee labor.  This implies that fringe is allocated not only to direct activities but indirect as well.  So in calculating rates, fringe must be allocated to the other indirect cost pools that include labor.  This is illustrated in the Indirect Cost Rate Illustrations.

Overhead:  The most widely accepted allocation base is Direct Labor.  Some contractors use the sum of Direct Labor and Fringe.  This is technically correct but is only needed if there are multiple fringe pools.  In most cases Direct Labor is adequate.  However including Fringe in the allocation base is acceptable, it just complicates the indirect cost calculations and application to bases. 

Material Overhead Pools - This is common in manufacturing operations where there is significant materials and subcontract, purchasing, inventory activity, etc.  It is also seen in construction type businesses.  This overhead pool accumulates the cost of purchasing, subcontract management and inventory activities.  Often contractors want to add a material handling charge to materials or subcontracts.  This is all fine and permitted by the FAR.  However, unless the contractor separately accumulates this cost for audit verification, a contractor cannot propose, invoice or claim this cost.  Applying a material handling rate and failing to accumulate these costs separately is a formula for disaster for sure.   In any event, the most commonly used allocation base for Material Overhead pool cost is Material and Subcontract Costs.

General and Administrative Expense (G&A) - This subject is a matter of great debate and controversy.  This is especially the case where there is significant third party direct costs such as Direct Material, Subcontract costs or Other Direct Costs like travel causing a distorted allocation of G&A costs.  Unfortunately the trend is that government procurement officials lean towards prohibiting paying G&A on these cost types and oversight officials such as DCAA take a more conservative approach and lean toward including these costs in the allocation base resulting in the lowest rate.  So to say the least the government is divided and they are not on the same page.  This is a problem with no apparent solution in sight.  However see Value Added base discussion below.

The CAS position and the DCAA position is the proper allocation base for G&A is the base that best represents the total business activity.  With all things equal the preferred allocation base is the Total Cost Input base.  This is defined as all costs less G&A expense or stated another way, direct costs, fringe, overhead and unallowable direct and overhead costs.

However, both the CAS and DCAA recognize that the total cost input base may not be equitable in all situations.  So in cases where a contract or a group of contracts incurs proportionately significantly more third party costs causing an inequitable allocation of G&A cost then an alternate allocation base will be required.  In this case a cost impact is required demonstrating the inequity.  In such cases the value added base is used (direct labor and fringe).  The bottom-line is that the allocation base selected must be representative of the entire business activity and must be equitable.  Absent some of these exceptions the Total Cost Input base is preferred by the government.

The allocation base selected must be consistently applied to all contracts. 

The Indirect cost pools and allocation bases are summarized in the table below.  That is the standard and generally accepted indirect cost pools and allocation bases without consideration for unusual situations.  I always recommend getting agreement with the government up front if at all possible.  This is not full-proof as auditors and opinions frequently change.  But it does hopefully bring some sanity to the process.  The worst scenario is to proceed down a certain path without government buy-in and years later have an auditor question your methodology.  So it is always best to get government buy-in as soon as possible and have the methodology reviewed annually versus being faced with a government realization many years later.  Granted a contractor cannot control what the government chooses but it certainly can try.

Table of Indirect Cost Pools and Allocation Bases

IV. Intermediate Cost Pools

Intermediate cost pools are not typically relevant to most small businesses but are applicable to some so I decided to include this discussion.  Intermediate cost pools arise when there are service centers present.  Any time you have a significant indirect cost that supports other indirect and direct departments or functions may require an intermediate cost pool.  In these cases, an alternate allocation base may be required for this sub-set of overhead.  The most common is occupancy or facilities, engineering support or reproduction.  For example, if there is a significant production or operations space versus G&A space or there are multiple buildings or facilities, an occupancy allocation from an intermediate pool may be required.

To be compliant, these costs need to be accumulated in an intermediate cost pool and allocated using a base that is considered equitable.  The allocation base is either an input or output base.  In the case of facilities or occupancy the most widely accepted base is square footage.  Functions will be allocated cost based on the square footage of that particular function or space.

V. Large Business Considerations

VI. Indirect Cost Rate Calculations (Illustrations)

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