Allocating costs during a Government Contract may be one of the most important aspects in accounting for that project and will determine whether it will result in a profit or loss. Direct Costs may be charged to the contract, while Indirect Costs may be less obvious but could enable you to break even or make that desired profit in the end. Luckily, most costs are outlined for you in the Federal Acquisition Regulation (FAR) which has been transmitted through the legal regulatory process. The FAR is considered to have the force and effect of law. Here is an outline of Direct Costs versus Indirect Costs and the application of those costs in a Government Contract.
Direct Costs are directly associated with completing the contracted work. Examples of Direct Costs are direct labor, material, and supplies used. Because these costs can be charged directly to the contract, allocations of these Direct Costs are strictly monitored. Part §31.202 of FAR explains that if two costs are incurred for the same purpose in similar situations, one cannot be labeled as a Direct Cost and another as an Indirect Cost. Additionally, the contractor does have the option to treat any Direct Cost of a minor dollar amount as an Indirect Cost, only if the accounting treatment is consistently applied to all final cost objectives and it produces substantially the same results as treating the cost as a Direct Cost.
Indirect Costs are those remaining costs to be allocated to the final cost objectives after Direct Costs are determined. Common Indirect Costs are Overhead (i.e. manufacturing, Research & Development) and General and Administrative (G&A) costs (FAR allows Bid & Proposal and Internal Research & Development expenses to be allocated as G&A). According to Part §31.203, Indirect costs are based on the application of provision, meaning what the contractor has established as the “logical cost groupings.” These groupings are logical evaluations with a reasonable rationale of why costs are Indirect, while staying consistent with FAR. Once the logical cost groupings have been accepted, the contractor may not modify it, unless in the event there is a significant change in the nature of the business. Excessive pass-through charges (charges by a contractor that do not “add value” to the contract) are not allowable and therefore not considered Indirect Costs.
As explained in §31.204, Application of Principles and Procedures, costs are allowable to the extent they are reasonable and allocable (outlined in §31.201). For Cost-Reimbursement, Fixed-Price Incentive, and Price Redeterminable contract types, costs incurred as reimbursements or payments to a subcontractor are allowable to the extent the reimbursements or payments are for costs incurred. To further explain if a certain cost is reasonable and allocable, §31.205 outlines most costs and how to report them. However, this section does not cover every element of cost and therefore you must base that item on a related item outlined in FAR. Examples of costs included in this section are depreciation (§31.205-11), Rental Costs (§31.205-36), and Travel Costs (§31.205-46).Written by: Stephanie Cox TGG Accounting