Welcome back to the Cost Corner, where we provide practical insight into the complex cost and pricing requirements that apply to Government contractors. This is the second article in a multi-part series on the Federal Acquisition Regulation (FAR) Cost Principles applicable to contracts with commercial organizations. The previous Cost Corner addressed the applicability of the Cost Principles and their general criteria for determining the allowability of costs. This Cost Corner focuses on the allocation of direct and indirect costs. We will address the applicable Cost Principles (FAR 31.202 and FAR 31.203) as well as the overlapping provisions of the Cost Accounting Standards (CAS) (CAS 402 and CAS 418), which include closely related but significantly more detailed (burdensome) requirements for CAS-covered contractors.

Cost Principles Coverage of Direct and Indirect Costs

A “direct cost” is any cost that is identified specifically with a particular final cost objective.[1] A “cost objective” is a function, organizational subdivision, contract, or other work unit for which the contractor accumulates and measures costs.[2] A “final cost objective” is a cost objective that receives an allocation of both direct and indirect costs and that is one of the final accumulation points in the contractor’s cost accumulation system.[3] A “final cost objective” is generally a contract. Thus, a “direct cost” is any cost that is identified with one and only one contract. For example, a contractor typically would treat the wages of employees providing services to a customer or working on a production line as direct costs because the contractor can track the amount of time the employee spends performing work for a particular contract.[4] Common categories of direct costs include material used for a particular contract (direct material), labor performed for a particular contract (direct labor), and other direct costs (ODCs, such as travel or special tooling costs, incurred for a particular contract.

All costs identified specifically with a particular contract are direct costs of that contract and the contractor must charge them directly to the contract.[5] All costs identified specifically with other final cost objectives are direct costs of those cost objectives and the contractor must not charge them to the contract either directly or indirectly.[6] However, for reasons of practicality, a contractor may treat any direct cost of a minor dollar amount as an indirect cost if the contractor consistently applies that accounting treatment to all final cost objectives and it produces substantially the same results as treating the costs as direct costs.[7]

An “indirect cost” is any cost not directly identified with a single final cost objective, but identified with two or more final cost objectives or with at least one intermediate cost objective.[8] In other words, indirect costs are the costs that remain to be allocated after the contractor has identified and charged all direct costs.[9]

The contractor must accumulate indirect costs by “logical cost groupings,” known as indirect cost pools, with due consideration of the reasons for incurring the costs.[10] Most indirect cost pools fall into one of three categories: fringe costs, overhead costs, and general and administrative (G&A) expense.

• Fringe costs are costs incurred for employees in addition to regular wages and salaries. Examples of fringe costs include costs incurred for vacations, sick leave, holidays, military leave, employer pension and 401(k) contributions, payroll and unemployment taxes, insurance, and other employee benefits.
• Overhead costs are costs incurred for the performance of multiple contracts. Examples of overhead costs include equipment, rent, depreciation, utilities, material storage and handling, property taxes, and management (other than senior management). Many contractors have multiple overhead pools, e.g., manufacturing overhead, engineering overhead, material overhead.
• G&A expenses are costs incurred for the general management and administration of the business as a whole. Examples of G&A expenses include costs incurred for senior management, accounting, finance, human resources, information technology, business development, sales, and marketing.

The contractor must then select an allocation base for allocating each indirect cost pool.[11] The selection of indirect cost pools and allocation bases should allocate costs to contracts in proportion to the benefit received from the activity that generates the costs.[12]

The FAR notes that achieving an equitable distribution of costs may require creating separate indirect cost pools for work performed at Government and contractor sites.[13] For example, separate overhead pools may be necessary where work performed at a Government facility receives significantly less benefit from overhead costs, such as those associated with facilities and administrative support, than work performed at the contractor’s facility.

The FAR requires the contractor to maintain an indirect rate structure that continues to produce an equitable allocation of costs as circumstances change. The contractor may need to revise its method of allocating indirect costs if, as the result of changed circumstances, that method no longer distributes costs to contracts in proportion to the benefit received.[14] This may occur where there has been a significant change in factors such as the nature of the business, the extent of subcontracting, the volume of sales and production, manufacturing processes, the contractors products or services, or other relevant circumstances.[15]

The FAR affords contractors broad discretion (little guidance) in establishing indirect cost pools and bases. The number of indirect pools can range from as few as one or two at a small professional services firm to more than a hundred at a diversified defense contractor. Small contractors with few contracts may use single-tier indirect rate structures in which the contractor allocates all indirect cost pools immediately to final cost objectives. Many large government contractors have multi-tiered indirect rate structures in which they allocate some of their indirect cost pools to intermediate cost objectives, which are then allocated to one or more other indirect cost pools and/or final cost objectives. However, when a contractor can achieve substantially the same results through less precise allocation methods, the FAR provides that “the number and composition of cost groupings should be governed by practical considerations and should not unduly complicate the allocation.”[16]

Once a contractor has selected an appropriate base for allocating an indirect cost pool, the FAR provides that the contractor may not “fragment the base” by removing individual cost elements.[17] All items required to be included in an indirect cost base must bear their pro rata share of indirect costs irrespective of their allowability.[18] For example, if a contractor has selected a total cost input base to allocate G&A cost, the contractor must include in the base all costs incurred by the contractor, whether allowable or unallowable.[19] This means that unallowable costs will absorb a portion of the contractor’s G&A, thereby decreasing the recovery of G&A from the Government.

The base period for allocating indirect costs must be the cost accounting period during which the contractor incurred and accumulated the costs.[20] For CAS-covered contractors, the contractor must follow CAS 406 in selecting the cost accounting periods to be used in allocating indirect costs.[21] For other contractors, the base period for allocating indirect costs must be the contractor’s fiscal year used for financial reporting purposes in accordance with generally accepted accounting principles.[22]

CAS Coverage of Direct and Indirect Costs

The CAS include more detailed (burdensome) criteria for the allocation of direct and indirect costs. Many of the CAS requirements pertain to specific types of indirect costs. For example, CAS 403 addresses the allocation of home office costs to business segments,[23] and CAS 410 governs the allocation of business unit G&A to final cost objectives.[24] CAS 418, the focus here, applies to the extent any other provision of the CAS does not require a different allocation.[25] The purpose of CAS 418 is to provide criteria for “the consistent determination of direct and indirect costs,” “the accumulation of indirect costs … in indirect cost pools,” and “the selection of allocation measures based on the beneficial or causal relationship between an indirect cost pool and cost objectives.”[26]

CAS 418 includes definition and concepts similar to FAR 31.202 and FAR 31.203. It defines a direct cost as “any cost which is identified specifically with a particular final cost objective,” i.e., a contract.[27] Correspondingly, an indirect cost is “any cost not directly identified with a single final cost objective, but identified with two or more final cost objectives or with at least one intermediate objective.”[28] CAS 418 requires the accumulation of indirect costs in indirect cost pools.[29] The contractor must allocate both direct and indirect costs to final cost objectives: “Allocate means to assign an item of cost, or a group of items of cost, to one or more final cost objectives. This term includes both direct assignment of costs and the reassignment of a share from an indirect cost pool.”[30] The allocation method guides the distribution of indirect costs to cost objectives and must distribute indirect costs to final cost objectives in a manner that reflect each cost objective’s fair share of the indirect costs.[31]

CAS 418 imposes three fundamental requirements on contractors subject to full coverage under the CAS. Those requirements are significantly more detailed than the Cost Principles governing the allocation of direct and indirect costs.

First, CAS 418-40(a) requires the contractor to have and consistently follow a written statement of accounting policies and practices for classifying costs as direct or indirect.[32] Contractors subject to full coverage under the CAS comply with this requirement by having a CAS Disclosure Statement.

Second, CAS 418-40(b) requires indirect cost pools to be homogeneous.[33] This is similar to the FAR requirement to accumulate indirect costs by “logical cost groupings with due consideration of the reasons for incurring such costs.”[34] Both are intended to ensure that indirect costs are allocated to cost objectives in reasonable proportion to the benefits received; however, the criteria for homogeneity are more specific. An indirect cost pool is homogeneous if each significant activity whose costs are included in the pool has the same or similar causal or beneficial relationship to cost objectives as the other activities whose costs are included in the pool.[35] It is also homogeneous if the allocation of the costs of the activities included in the indirect cost pool results in an allocation to cost objectives that does not materially differ from the allocation that would result if the costs of the activities were allocated separately.[36] Conversely, in order to establish that an indirect cost pool is not homogeneous, the Government must prove that the costs of all significant activities in the cost pool do not have the same or a similar beneficial or causal relationship to cost objectives and allocating the costs separately would result in a materially different allocation.[37]

The homogeneity requirement generally increases the number of indirect cost pools. Returning to the example from FAR 31.203(f), if the work a contractor performs at a Government facility receives significantly less benefit from overhead costs, such as those associated with facilities and administrative support, and, if allocating the costs separately would produce a materially different result, then a single overhead pool for work performed at Government and contractor facilities would violate the homogeneity requirement. CAS 418 provides another example related to the proliferation of overhead pools, specifically a contractor that includes the indirect costs of machining and assembling activities in a single manufacturing overhead pool.[38] If the machining activity does not have the same or similar beneficial or causal relationship to cost objectives as the assembling activity, e.g., if some contracts benefit more from manufacturing and other contracts benefit more from engineering, and if allocating the cost of the machining activity separately from the cost of the assembly activity would produce a materially different result, then the single manufacturing overhead pool would not be homogeneous and the contractor would be required to create separate pools.[39]

Third, CAS 418-40(c) requires the contractor to allocate pooled indirect costs to cost objectives in reasonable proportion to the beneficial or causal relationship of the pooled cost to cost objectives.[40] This is similar to the FAR requirement to allocate indirect cost pools “on the basis of the benefits accruing to intermediate and final cost objectives.”[41] However, CAS 418 provides specific criteria for selecting the allocation base.

If a material amount of the costs included in an indirect cost pool are costs of management or supervision of activities involving direct labor or direct material costs, resource consumption cannot be specifically identified with cost objectives, and CAS 418 requires a base that is representative of the activity being managed or supervised.[42] In that circumstance, the contractor must use a direct labor hour base or a direct labor cost base, whichever is more likely to vary in proportion to the costs included in the indirect cost pool being allocated, except that the contractor may use: (1) a machine-hour base, if the costs in the cost pool are comprised predominantly of facility related costs (e.g., depreciation, maintenance, and utilities); (2) a units-of-production base, if there is common production of comparable units; or (3) a material cost base, if the activity being managed or supervised is a material-related activity.[43]

If an indirect cost pool does not include material amounts of the costs of management or supervision of activities involving direct labor or direct material costs, CAS 418 requires the pooled costs to be allocated by means of the following allocation bases listed in descending order of precedence: (1) a resource consumption measure; (2) an output measure; or (3) an a surrogate that is representative of resources consumed.[44] If practical, the contractor must use a measure of resource consumption of the activities of the indirect cost pool (e.g., machine usage hours for computer or reproduction equipment, flight hours for company aircraft).[45] If consumption measures are unavailable or impractical to obtain, the contractor may use a measure of the output activities of the indirect cost pool (e.g., number of printed pages for reproduction, number of reports for computer center).[46] If neither resources consumed nor output of the activities can be measured practically, the contractor may use a surrogate that varies in proportion to the services received.[47] Such surrogates generally measure the activity of the cost objectives receiving the service (e.g., requisitions received from each requesting activity for reproduction or computer service effort).[48]

Consistency in Allocating Direct and Indirect Costs

The FAR requires consistency in allocating costs incurred for the same purpose. With respect to direct costs, FAR 31.202 provides: “No final cost objective shall have allocated to it as a 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.”[49] With respect to indirect costs, FAR 31.203 provides: “No final cost objective shall have allocated to it as an indirect cost any cost, 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.”[50] A recent case applying these requirements explained that a contractor that had consistently allocated a certain type of costs (field office costs) as indirect costs could not then attempt to recover them as direct costs because this would result in a double recovery.[51]

The introductory sentence of CAS 402-40 summarizes the fundamental requirement for consistency in allocating costs incurred for the same purpose more concisely: “All costs incurred for the same purpose, in like circumstances, are either direct costs only or indirect costs only with respect to final cost objectives.”[52] The purpose of CAS 402 is to “require that each type of costs is allocated only once and only one basis to any contract or other cost objective” and to “prevent double counting,” which may occur when costs are allocated directly to a cost objective without eliminating like costs from indirect cost pools that were allocated to the cost objective.[53]

For contractors subject to disclosure requirements, the CAS Disclosure statement requires the contractor to set forth its cost accounting practices with regard to the distinction between direct and indirect costs, including the treatment of costs that are sometimes accounted for as direct and sometimes account for as indirect, depending on the circumstances.[54] According to CAS 402, by distinguishing between direct and indirect costs, and by describing the criteria and circumstances for allocating items that are sometimes direct and sometimes indirect, the CAS Disclosure statement will be “determinative” as to whether costs were incurred for the same purpose.[55] For contractors that have not submitted a Disclosure Statement, the determining of whether specific costs are directly allocable to contracts is based on the contractor’s cost accounting practices at the time of a contract proposal.[56]

CAS 402 has generated multiple disputes regarding the extent to which a contractor has incurred costs for the same purpose under like circumstances. The cases establish, among other things, that costs incurred pursuant to a contract requirement are not incurred for the same purpose under like circumstances as similar costs incurred in the absence of a contractual requirement. One case held that CAS 402 permitted a contractor to treat the cost of work performed under a cost-plus-fixed-fee subcontract as a direct cost of that contract, but the cost of work performed after expiration of the contract as an indirect cost because there was no longer any requirement to perform the work.[57] Another case held that a contractor did not violate CAS 402 by treating bid and proposal costs incurred pursuant to a contractual requirement as direct costs of the relevant contract but bid and proposal costs incurred for the same but not pursuant to a contractual requirement, as indirect costs.[58]

CAS 402 also addresses the circumstances where the contractor’s disclosed cost accounting practices would result in an inequitable allocation of indirect costs incurred for the same purpose.[59] In such circumstances, the contractor may either: (1) reassign such costs using a method that would provide an equitable distribution to all final cost objectives or (2) directly assign such costs to final cost objectives with which they are specifically identified.[60] In either case, the contractor must amend its Disclosure Statement to reflect the changed cost accounting practices involved.[61]

Finally, FAR 31.202 and CAS 420 both permit a contractor to treat any direct cost of a minor dollar amount as an indirect cost for reasons of practicality where the accounting treatment for such cost is consistently applied to all final cost objectives – but only if such treatment produces results that are substantially the same as the results of treating such costs as a direct cost.[62]

Conclusion

This article has addressed the allocation of direct and indirect costs. The next edition of the Cost Corner will address accounting for unallowable costs.

FOOTNOTES

[1] FAR 2.101.

[2] FAR 31.001.

[3] Id.

[4] See Sikorsky Aircraft Corp. v. United States, 773 F.3d 1315, 1318 n.2 (Fed. Cir. 2014).

[5] FAR 2.101; FAR 31.202(a).

[6] FAR 2.101; FAR 31.202(a).

[7] FAR 31.202(b).

[8] FAR 2.101.

[9] FAR 31.203(b).

[10] FAR 31.203(c).

[11] FAR 31.203(c).

[12] FAR 31.203(c).

[13] FAR 31.203(f).

[14] FAR 31.203(e).

[15] FAR 31.203(e).

[16] FAR 31.203(c).

[17] FAR 31.203(d).

[18] FAR 31.203(d).

[19] FAR 31.203(d).

[20] FAR 31.203(g).

[21] FAR 31.203(g)(1).

[22] FAR 31.203(g)(2).

[23] CAS 403-20.

[24] CAS 410-20.

[25] CAS 418-40(d).

[26] CAS 418-20.

[27] CAS 418-30(a)(2).

[28] CAS 418-30(a)(3).

[29] CAS 418-40(b).

[30] CAS 418-30(a)(1).

[31] Sikorsky Aircraft Corp v. United States, 102 Fed. Cl. 38, 41 (2011).

[32] CAS 418-40(a).

[33] CAS 418-40(b).

[34] FAR 31.203(c).

[35] CAS 418-50(b)(1).

[36] Id.

[37] CAS 418-50(b)(2); see also Sikorsky Aircraft Corp. v. United States, 773 F.3d 1315, 1325 (Fed. Cir. 2014); AM General LLC, ASBCA No. 53610, 54741, 06-1 BCA ¶ 33,190.

[38] CAS 418-60(d).

[39] Id.

[40] CAS 418-40(c).

[41] FAR 31.203(c).

[42] CAS 418-40(c)(1).

[43] CAS 418-50(d)(2).

[44] CAS 418-40(c)(2).

[45] CAS 418-50(e)(1).

[46] CAS 418-50(e)(2).

[47] CAS 418-50(e)(3).

[48] Id.

[49] FAR 31.202(a).

[50] FAR 31.203(b).

[51] Active Constr., Inc., CBCA No. 6597, 22-1 BCA ¶ 38,070.

[52] CAS 402-40.

[53] CAS 402-20.

[54] CAS 402-50(b).

[55] CAS 402-50(b).

[56] CAS 402-50(c).

[57] Unisys Corp., ASBCA No. 41135, 94-2 BCA ¶ 26,894.

[58] ATK Thiokol, Inc. v. United States, 598 F.3d 1329 (Fed. Cir. 2010).

[59] CAS 402-50(d).

[60] CAS 402-50(d).

[61] CAS 402-50(d).

[62] FAR 31.202(b); CAS 402-50(e).