One solution for such inequitable cost allocations would be to include the cost of contract labor in the direct labor cost allocation base for overhead. For pricing purposes, when average direct labor rates are used, the cost of contract labor would have to be included with contractor employee costs to determine an average rate. This has the result of increasing direct rates and lowering overhead (because of the high denominator number).

Commonly, contract labor rates per hour are greater than employee rates especially when a company is providing the purchase labor because they may be paying limited fringe benefits and are including a markup. If the entire amount was a direct charge it might be inequitable because fringe benefits for employees would be allocated to direct labor which includes employees and contract labor, where the later already may include fringe benefits and markup. Consequently, contract labor charges may be excessive if they include two fringe benefits allocations (e.g. one from the subcontracting company and one from the contractor) and the markup would be charged only to that contract(s) where the contract labor is used and not to others.

When the rate difference is substantial, other cost accounting techniques may be necessary. One method would be to segregate the invoice from the company (or from the individual consultant or contract employee) into a direct labor cost portion and an overhead portion. The justification for this treatment is that the invoice is comparable to the direct charge plus some overhead of contractor employees. The segregation of costs can be accomplished in three ways:

1. Segregate the direct labor cost portion based on the direct labor rate of a comparable employee and allocate the remainder of the cost to overhead pools.
2. Segregate the direct labor cost portion based on invoice information from the provider.
3. Prorate the invoice to direct labor and overhead based on the ratio of direct labor to overhead experienced by the contractor.

 Though Option 1 is the most common method, the concept underlying all three has been validated by an Armed Service Board of Contract Appeal decision (Software Research Associates, ASBCA 88-3 BCA). In the case, the contractor entered into a time and materials contract where all-inclusive fixed rates for various labor categories were established. During contract performance, the contractor used contract employees and billed at the rate established for direct labor categories. The government argued this labor could not be billed as direct labor because the labor was performed by non-employees resulting in an unfair windfall for the contractor. Rather the contract labor should be invoiced as an “other direct cost” or as “material” of the T&M contract.

The Board disagreed because the work performed by the contract employees was indistinguishable from that provided by contractor employees. The government’s windfall argument was insufficient to overcome this fact and the Board concluded one of the three methods (or a similar alternative) identified above would be acceptable provided the method used was consistent with the way it booked charges for government reporting purposes.