ALLOCATING COSTS

The government will pay only for costs that it believes relate to or benefit its work. The process of assigning costs to government and commercial contracts is known as cost allocation. When the government requires that a cost be allocable to a government contract, it means that the cost is for something that benefits the government work or is necessary for the government work.

Proper cost allocation requires an understanding of the types of costs involved on a contract. Costs must then be applied consistently within an acceptable cost structure.

Direct and Indirect Costs

Direct costs are costs incurred solely for the benefit of a single final cost objective, such as a contract. Indirect costs benefit more than one contract. FAR 31.202 defines a direct cost as any cost that “can be identified specifically with a particular final cost objective. No final cost objective shall have allocated to it as direct cost any cost, if other costs incurred for the same purpose in like circumstances have been included in any indirect cost pool to be allocated to that or any other final cost objective. Costs identified specifically with the contract are direct costs of the contract and are to be charged directly to the contract. All costs specifically identified with other final cost objectives of the contractor are direct costs of those cost objectives and are not to be charged to the contract directly or indirectly.”

Direct costs are those specifically identified to various cost objectives within the company. They normally include the salaries and wages of personnel directly associated with these objectives, materials or services directly used in manufacturing the product, subcontracted costs, and other direct costs directly related to the cost objectives. A direct cost may be one for materials or services incorporated into the product or the production process.

Indirect costs are all costs that cannot be specifically identified with a single contract or with units of output because the cost either is incurred for more than one contract or unit of output or is not susceptible to measurement at the unit of output level. Such costs are necessary to produce units of output and are as much a cost of producing goods and services as costs that are specifically identified, such as direct labor and direct material.

FAR Subpart 31.203 defines an indirect cost 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. After direct costs have been determined and charged directly to the contract or other work, indirect costs are those remaining to be allocated to the several cost objectives. 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.”

Indirect costs are commonly separated into overhead and G&A costs. A business may have several overhead cost pools, but only one G&A cost pool. Small companies often combine overhead and G&A into a single cost pool, whose title might be indirect cost pool, overhead cost pool, or G&A cost pool. The number of overhead cost pools at a business depends on the circumstances.

A small company might have one indirect cost pool and rate for both overhead and G&A costs. A larger company might have a single overhead pool for indirect costs related to contract performance and a G&A cost pool for overall operations costs. Additionally, a large contractor that has several functions or locations might use overhead pools. For example, the contractor could have one overhead cost pool for plant A and another for Plant B. There could also be one overhead pool and rate for work performed at the customer site and another for work performed at the contractor site. The contractor could have a separate overhead cost pool for materials and subcontract functions. In this latter example, the production overhead would likely be allocated based on direct labor dollars and the overhead related to ordering and handling materials would likely be allocated based on material and subcontract dollars.

Overhead Costs

Overhead costs are those not directly related to cost objectives but are support-type costs necessary for the production of goods or services. These costs may be associated with general product lines, organizational groups, or groups of contracts. Overhead costs commonly include salaries and wages of support and production personnel, facilities costs, and supplies.

Overhead costs are accumulated into overhead pools. The number of pools can vary depending on the complexity of operations. Each overhead pool is allocated to cost objectives in reasonable proportion to the beneficial or causal relationship of the pool(s) to cost objectives. Overhead costs are commonly expressed in a rate as follows:

Manufacturing automation has grown immensely and has created another aspect of overhead allocation. As direct labor disappears in an automated environment, using direct labor as an allocation base no longer is logical. Activity-based costing (ABC) seeks cost drivers as cost allocation bases. For example, instead of allocating overhead based on direct labor dollars or hours, overhead is allocated based on machine time, operator-maintained work stations, etc. Instead of allocating material-related overhead based on material costs, this overhead is allocated based on the number of items purchased, the quantity of items passing through inventory, the number of times material is moved, etc.

Service Centers

A contractor service center furnishes services to others within a company. Good examples are the computer mainframe installations that provide shared services for other corporate segments. Complex algorithms are usually calculated for work done in these centers. The algorithms will include charges for mainframe time as well as ancillary equipment utilized in running programs for users.

Another example of a service center is a testing facility, which can range from a wind tunnel to an environmental test lab. A type of machine utilization rate may be calculated for the type of tests being performed. Some of the testing service center rates can be quite large due to the expensive original cost of the equipment and the specialized housing necessary for this equipment. Other service center examples include copying or reproduction centers, graphic arts, technical library, automobiles, and aircraft.

General and Administrative Costs

G&A costs are defined as “Any management, financial, and other cost which is incurred by or allocated to a business unit and which is for the general management and administration of the business unit as a whole.” These costs normally include compensation of company executives and their related fringe benefits, legal and professional fees, and other administrative personnel and costs.

G&A costs are frequently accumulated in a single pool and are allocated to the entire business unit based on the total cost input by way of a rate expressed as follows:

In the total cost input G&A allocation method, all costs (labor, overhead, material, and other direct charges) are included in the G&A allocation base. An alternative G&A allocation method is called the “value added” method and would be expressed as follows:

A third allocation method is called the single element method. This method uses only one cost element (e.g., labor as an element of the base) to allocate G&A costs. It is not used too often, however, because the smaller the base employed, the larger the G&A rate will be. This unfortunately does not present a readily acceptable, saleable G&A rate. In most instances, the lowest G&A rate possible presents a more acceptable selling point:

There have been numerous debates and a few court decisions regarding which G&A allocation method is the most acceptable. The CAS allow any of these methods. However, a non-CAS-covered business unit is not restricted to the use of only these three G&A allocation bases.

The Defense Contract Audit Agency (DCAA) has generally advocated the total cost input method as the only acceptable method. Case history indicates that the courts have not agreed with that philosophy and have allowed any of the three methods to be used based on the contractor’s selection and the equity of the resulting allocations.

Another aspect of G&A costs is multiple layers of G&A costs. These layers are represented by several different labels, such as a group or a sector. These units usually have cognizance over a number of divisions or segments producing goods and services. For contracts subject to full CAS coverage, corporate allocations are governed by CAS 403. Basically, corporate or group costs are identified as much as possible to specific segments, or groups of segments. The residual expenses, which cannot be identified, are then reviewed as a percentage of total revenue. If the residual expenses exceed specified percentages, these expenses must be allocated by a method called the “three factor formula.” This formula includes revenues, payroll, and net book value of assets.

Consistent Application

With regard to the accumulation and allocation of direct and indirect costs, both the FAR and the CAS emphasize the need for consistent allocation of costs incurred for the same purpose in similar circumstances. This fundamental requirement of government contract costing serves as a foundation in the development of any accounting system. The CAS provide specific criteria for the accumulation and allocation of both direct and indirect costs. They describe the nature of these costs and include guidance in determining acceptable, indirect allocation bases. In circumstances where the CAS do not apply to contracts, the method of allocation is to be in accordance with consistently applied GAAP and causal-beneficial relationships.

According to the FAR, the base period for allocating costs is the cost accounting period during which such costs are incurred and accumulated for distribution to work performed in that period. For contracts subject to full CAS coverage, the cost accounting periods to be used in allocating indirect costs are governed by CAS 406. This requirement is also incorporated in the FAR. For contracts subject to modified CAS coverage and for contracts not subject to CAS coverage, the base period for allocating indirect costs will normally be the contractor’s fiscal year.

Establishing a Cost Structure

When an offeror or a contractor must create a cost structure for government contracting, a spreadsheet application is helpful. The first column of such a spreadsheet contains all the nominal accounts, i.e., revenue and expense accounts. The second column presents the amount from the most recent cost accounting period or an estimate for the current cost accounting period, if this is available.

Each amount is then assigned to a column for direct labor costs, material and subcontract costs, other direct costs, fringe benefit costs (if applicable), overhead cost pool(s), and G&A. Columns for unallowable costs should also be included. The totals on these columns are used to develop cost allocation bases and cost pool amounts. A check figure can be developed to ensure that all general ledger costs are accounted for in the government cost structure. Figure 21 demonstrates this application.

Many variations are possible in Figure 21. For example, multiple overhead cost pools are common; the most common is an overhead cost pool for materials and subcontracts. Other overhead cost pools might be for contractor site and client site work, physical location, business line, profession discipline, etc.

Monitoring Indirect Costs

Indirect cost rates should be monitored to prevent over- or under-invoicing of cost-type contracts and to ensure that business decisions are based on accurate information. Rates should be monitored at least monthly, preferably quarterly. Annual revisions to interim billing rates are not required by the FAR, but agencies such as DCAA may demand that such revisions be submitted in advance of each fiscal year. Interim billing rate adjustments should be requested at any time rates are expected to vary significantly from actual rates at year-end. The test is what is expected at year end, not the year-to-date rate. At the completion of the year, DCAA encourages contractors to adjust indirect cost rates to reflect actual rates prior to audit. This is not required by the FAR, but is often a good idea to prevent under- or over-billings.