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Approved Accounting System for Government Contracts: How to tell if a cost is direct or indirect…Does it matter?

Can you look at your company’s costs and tell which costs are direct or indirect? If you can’t, understanding the difference between direct and indirect costs is a critical first step in your plan to get a compliant and approved cost accounting system for Government Contracting.

As I mentioned in my previous blog post “What you should know about having an ‘approved’ accounting system for government contracting”,  a compliant government cost accounting system must:

  • Track all costs for any individual government contract
  • Accumulate actual direct costs by labor category and job/task
  • Accumulate actual indirect costs and …

We need to track all the costs for each individual government contract. To do this, I use a General Ledger and a Subsidiary Job Cost Ledger that I manually link to the General Ledger. I record all our company’s costs in the General Ledger and track all the costs for each individual contract in the Subsidiary Job Cost Ledger.

Since we track all costs both direct and indirect, why do I care whether a cost is direct or indirect? It’s because direct and indirect costs are tracked and applied to contracts differently.

We must accumulate actual direct costs by labor category and job/task. In order to track the actual direct costs, we must know how to identify a direct cost and be able to differentiate the direct costs from the indirect costs.

Let’s start by looking at the definition of a direct cost in Federal Acquisition Regulation (FAR) 2.101. You can also check FAR 31.202 that supplements this broad definition with more details.

A direct cost is “any cost that can be identified specifically with a particular final cost objective” (i.e., cost incurred for a specific contract).

Examples of direct costs are:

  • Direct labor is a direct cost. This is labor cost that is identified to a single cost objective (such as contract). It must be identified to a labor category and applied at the job/task level.
  • Direct material is also an example of a direct cost that is not a labor cost. It is a direct cost which must be identified at the job/task level.

We must also accumulate actual indirect costs and …. To do this I use specific Accounts in the General Ledger where I accumulate the actual indirect costs. I also use the Subsidiary Job Cost Ledger to record the indirect labor. But, we must be able to identify indirect costs.

So now let’s look at the definition of an indirect cost in FAR 2.101.

An indirect cost is defined as “any cost not directly identified with a single, final cost objective, but identified with two or more final cost objectives or an intermediate cost objective. It is not subject to treatment as a direct cost.”

Indirect costs shall be accumulated by logical cost groupings.

  • Further, an indirect cost shall not be allocated to a final cost objective if other costs incurred for the same purpose in like circumstances have been included as a direct cost of that or any other final cost objective.
  • Because of their nature, indirect costs cannot be charged to final cost objectives on an individual basis. Therefore, indirect costs must be classified and grouped together into indirect cost pools, typically either an overhead cost pool or the general and administrative expense (G&A) cost pool.
  • Examples of some logical cost groupings are fringe benefits costs, manufacturing overhead costs, engineering overhead costs, general and administrative costs.

The next requirement regarding Indirect costs is that the accumulated indirect costs that are in a logical cost grouping shall be allocated to several cost objectives using an allocation base.

Remember that more detailed information can be found in the Federal Acquisition Regulations. See below where to find it.

Federal Acquisition Regulations can be found at Title 48 includes regulations for many government agencies. Title 48, Part 31 discusses Contract principles and Procedures. Subpart 31.2 discusses Contracts with commercial organizations and includes explanations of composition of total costs, direct costs, indirect costs and application of principles and procedures to name a few of the topics.

What do you think? Are you ready for government contracting? Check back for more discussions about the elements of a compliant cost accounting system.

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