(Editor’s Notes. Whether it be pricing new government work, undergoing audits of your accounting system, establishing your own contract accounting practices or preparing a Disclosure Statement decisions on what costs are direct versus direct represent the fundamental first step. We came across a good article in the May 2008 issue of the CP&A Report by Darrell Oyer that inspired this article and we use both its insights and our experience as consultants and DCAA auditors here.)

The first step in establishing a firm’s accounting system for accumulating costs on government contracts is to determine what costs will be treated as direct and which costs are indirect. After that decision is made then contractors will decide its indirect rate structure (number of indirect rates and what costs will be included in the pool and bases of each rate). The importance of the decision can be critical: (1) the FAR and CAS address the issue requiring compliance (2) direct costs are billable, dollar for dollar, to the client (3) the more costs that are classified as direct, the lower the indirect rate may be and (4) since the theoretical goal is to allocate all costs directly to specific final cost objectives, the more costs that are direct the more precise and hence closer to the goal.

The FAR defines direct costs as “No final cost objective shall have allocated to it as a direct costs 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. Direct costs of that contract shall be charged directly to the contract.” The definition in the Cost Accounting Standards is more pointed – “Direct cost means any cost which is identified specifically with a particular final cost objective.”

Both the FAR and CAS contain safeguards against inequitable cost allocations that would result if costs incurred for the same purposes under like circumstances were charged direct to some cost objectives and indirect to others. CAS 402 contains an illustration of costs that appear similar but are not incurred for the same purpose – in addition to 10 firemen employed for protection of the plant, which are charged indirect, the contractor also uses 3 firemen to protect flammable materials for one contract, which are charged direct to that contract. Such different treatment of apparently similar costs must be disclosed as showing the different purposes for each type of costs. Examples of similar sometimes direct and sometimes indirect expenses include tooling costs (general versus special), security costs (general versus special facilities), training (training benefiting all contracts versus required or benefiting only one contract), software (common-use versus special purpose needed for one contract) and meeting costs (general meeting versus contract-specific).

A long established approach to identifying direct costs is the “but for” rule – if a cost would not have been incurred “but for” the contract, that indicates it is properly allocable to the contract while if it would have been incurred even if the contract did not exist, then it would more properly be an indirect cost. This “but for” rule is “causal” – the contract caused the cost to be incurred but sometimes a better approach might be a “beneficial” basis – the cost benefited one or more contracts. Sometimes there is a conflict that needs resolution using judgment – for example, a government contract may have caused a company to install a security fence but the fence benefited all company work.

Both the FAR and CAS use materiality considerations. For practical purposes, any direct costs of a minor dollar amount (not defined) may be treated as an indirect cost provided the accounting treatment is consistently applied and the result is substantially the same (again not defined). This concept is often incorporated in the term “blanket costs” where examples may include miscellaneous small parts or product inspection labor. Contractors may have the option of considering these costs to be indirect or they may be pooled and allocated directly to final cost objectives on some appropriate base. We find that care should be taken to ensure the government will pay for these costs directly – it is quite common for them to assert these costs will only be paid indirectly where if they were proposed direct and hence excluded from the indirect cost pool, recovery would be precluded.

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