(Editor’s Note. While reading an interesting article in the May 2008 issue of CP&A Report by Darrell Oyer, we were struck by a footnote quoting results of a 1979 study by the CAS Board analyzing the practices of various contractors’ treatment of a wide assortment of costs. We found both the results and discussion relevant to current issues we encounter in our consulting practice when helping clients decide how to treat specific types of costs. The following addresses the results of that 1979 report and also incorporates some of Mr. Oyer’s remarks that we allude to.)
Basic Rules
The Federal Acquisition Regulation and Cost Accounting Standards pretty much duplicate the requirements for distinguishing direct and indirect costs. The article addresses some of the key FAR and CAS rules affecting the distinction between direct and indirect costs that we summarize here. The FAR definition states “No final cost objective shall have allocated to it as a direct cost any cost or other costs incurred for the same purpose in like circumstances have been included in any indirect cost pool…” In the CAS definition, Direct cost means “any cost which is identified specifically with a particular final cost objective.” Direct costs are not limited to those items incorporated in the end product such as material and labor where costs identified with other cost objectives are direct costs of those cost objectives.
Both the FAR and CAS emphasize that costs incurred for the same purpose under like circumstances are not to be charged direct to some final cost objectives and indirect to others. This concept is reinforced by CAS 402 which repeats the concept. The FAR also elaborates on the concept in addressing “double accounting” or “double charging” – “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 indirectly.”
Same or different purpose. Oftentimes an analysis is needed for making direct/indirect determinations using the same purpose approach. The author provide several examples such as general tooling versus special tooling for a contract; general guard services versus special facility guard services for one contract; training courses benefitting all contracts versus training required for one contract; common-use software versus special purpose software needed for one contract; and general meeting versus contract-specific meetings.
Materiality. Both the FAR and CAS incorporate materiality concerns in the definitions stating that for “reasons of practicality” contractors may treat direct costs of “a minor dollar amount” as indirect as long as it is consistently applied and produces “substantially” the same result.
Blanket costs. “Blanket costs” are labor and material costs accumulated in an intermediate pool and reallocated to contracts as a direct cost. For example, small parts or inspection labor used in production and assembly meet the definition of a direct cost but because of the small dollar value or high number of transactions they are more efficiently allocated than discretely assigned to each final cost objective. Though the CAS describes blanket costs as being reallocated to final cost objectives as direct costs, in practice, such costs might be part of an indirect cost pool e.g. small parts included in a material handling pool.
Considerations for Making the Decision
In addition to complying with FAR and CAS requirements other issues to consider are:
1. Direct costs are specifically billable to customers. A direct charge allows dollar for dollar recovery plus a prorate share of indirect costs rather than the indirect costs only that may be subject to limitations.
2. Lowers indirect rates as more costs are classified direct. Rather than increasing costs by putting costs in indirect pools, allocating costs directly take those costs out of the pool and into the base resulting in a lower rate.
3. Less problems with cost allocations. The more costs are charged direct means less decisions on how to allocate indirect costs.
4. Greater precisions versus practicality. Extensive classifications of costs as direct definitely provides greater precision in allocating costs but involves more effort in classifying, recording and reporting costs. For example, reproduction costs can be allocated to all work, commercial and government, as indirect on say a direct labor base or allocated directly based on copies applicable to direct and indirect projects. Record keeping required to identify all costs in the pool and all copies made is often quite difficult where auditors commonly scrutinize these areas quite carefully and can disallow all reproduction costs when they find inaccuracies.
5. Resistance by customer. Direct cost allocation can draw attention to the fact it is direct where the customer may not want to pay for such items. Taking the reproduction example, customers might object to them as direct or disagree with the volume or unit prices used to cost copies. In such cases, especially during negotiations, a contractor may need to concede these costs, resulting in not recovering any costs rather than recovering a portion of those costs if they are a cost element in an indirect cost pool.
6. Relative benefit. Federal contracts may cause more or less costs to be incurred than say commercial contracts so the contractor may want to devise other means of allocating those costs proportionately than including them in an indirect cost pool. Using methods to allocate costs directly through either direct identification of those costs to a contract (e.g. subcontracting, travel) or a service center (e.g. copying, vehicles, computers) may provide better results.
The following reflects both the results of the CAS Board survey results as well as some comments by Mr. Oyer in his article.
Costs that are Generally Indirect
Some costs are generally charged indirect even though detailed accounting and tracking provide the opportunity to charge direct. For example, sale of scrap and salvage is usually credited to indirect costs to avoid the administrative burden of tracking such immaterial costs. While tracking purchasing and subcontract administrative functions directly on large contracts can be done relatively easily, such effort on smaller contracts are more difficult where, for example, employees accurately tracking their time spent can result in 20 time sheet entries every day, leading to allegations of improper labor recording. Though rarely used, the author suggests an interesting solution (we have recommended it ourselves several times): allocate purchasing and subcontract administration directly to the large contracts and allocate the costs for “non-major contracts” to a cost pool allocated only to those smaller contracts. The downside is dealing with another indirect cost rate and responding to allegations of CAS 402 noncompliance (the same costs are allocated directly and indirectly). The latter is not valid because one class of contracts is being charged its costs directly while the other class of contracts are being charged indirect for those costs – no contract receives both a direct and indirect allocation.
Training and computer operations were recorded indirect as well as rearrangement costs. Though not addressed in the report, DCAA informs its auditors that for items other than approved tooling, machinery and equipment and in the absence of specific contract coverage, the auditor is to question capital items. However, in practice, direct charging of equipment is not uncommon and often justified. For example, refrigerators needed to store specimens for a contract should be a direct charge where other work might not use refrigerators. Though they could be identified to specific contracts (some with significant administrative effort), overnight mailing, courier services, long distance phone calls, cell phones, faxes, copying, auto mileage, software, supplies and office space are usually charged indirect. The author is old enough (as well as I) to remember some of these costs were more costly than now where they might have been charged direct but lower costs and substitute alternatives make them indirect.
Costs That are Generally Direct
When material, the report indicated freight in and out, design engineering, drafting, shift premium, preproduction costs, line inspection, travel, packaging and preservation, royalties, warranty, rework and scrape work were generally charged direct. Recognizing that DCAA guidance states warranty costs are either direct or indirect auditors are advised to ensure that when they are in overhead to ensure the allocation base (e.g. direct labor) consists of only contracts having warranty provisions and when charged direct, ensure those same type of costs incurred on other contracts are excluded from overhead unless no cost duplication can be shown.
Some costs are almost exclusively charged direct such as subcontracts, trade discounts, refunds and allowances on purchases, purchased labor (on site and off-site), special tooling and special test equipment. For any capital items, such as special equipment and tooling charged direct DCAA advises that the contract authorizes it and that unauthorized costs not be included in other cost accounts such as material, supplies or fabrication.
Occasionally costs normally considered indirect are properly direct if unique contracting situations apply. The CAS report indicated certain employee related costs like health insurance, pension and vacation pay were charged direct about 10% of the time. This may be common for service contracts where employees are dedicated to a single contract and distinguishing between direct labor and indirect labor would be inconsequential because all labor would be charged direct to the contract. A case ruled that vacation pay charged direct was not prohibited if the resulting allocation was equitable.
Costs not Direct or Indirect
Several costs in the CAS report were not clearly direct or indirect. These costs included overtime premium, cash discounts, incoming material inspection, inventory adjustments and holiday differential pay. As for overtime premium payments, DCAA advises that though it is generally treated indirectly, it is acceptable as a direct cost when a contractor’s established policy provides for it. The author states charging overtime premium indirect has some advantages: (1) if direct, a customer may fear a contractor schedules its overtime work for its contract while if indirect, there is no opportunity for such gamesmanship and (2) if direct, it will be highly visible during contract negotiations, creating objections and possible elimination from fixed price contracts. (Editor’s Note. Be aware that we are seeing increasing objections to inclusion of overtime premiums in overhead by many state agencies such as Departments of Transportation.)
Minor cash discounts are almost always indirect and would be burdensome tracking them direct. Incoming inspections as a direct cost could be problematic, especially when material resources planning systems are used. The incoming material could be assigned to inventory or initially charged to a contract but subsequent transfers to other contracts having greater needs can create problems. Inventory adjustments may be difficult to track to specific contracts but some equitable adjustments would be needed if the inventory was used by multiple contracts. Holiday differential pay may be direct charged as an other direct cost or included in overhead (even fringe benefit pools). Including this cost in the labor rates, however, does not provide visibility that management may want for cost control while allocation directly can cause similar problems as those for overtime premium.
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