The amount of expenses claimed on long term contracts depends on the accounting method used to allocate costs.  Direct costs defined in IRC Section 451 defines direct material and labor costs.  Direct material includes material that is an integral part of the contract as well as materials consumed in the ordinary course of completing the items.  Direct labor includes regular pay, overtime, vacation and holiday pay, sick leave, overtime payroll taxes and unemployment insurance.  Indirect costs rules are similar to those encountered by government contractors and are considered those “incident to and necessary for” performance of the contract.  Certain costs are required to be included such as indirect labor, rework, research, indirect materials, rent and repair.  Other costs are optional such as marketing,  G&A expenses, income taxes and interest.  Indirect costs should be allocated to long term contracts using either (1) a specific identification method that would might use a separate set of accounts or (2) burden rates based on computed ratios of direct and indirect costs.  For those firms using the completed cost method, less costs are allowed to be allocated as indirect costs resulting in fewer current deductions.

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