Understanding the difference between direct and indirect costs, as well as overhead and G&A costs, is fundamental to complying with Federal Acquisition Regulations.
Also see “Accounting 101 for Government Contractors: Allowable vs. Unallowable Costs”
If your organization is entering into a contract with a federal agency for the first time, you’ll find your finance department dealing with a host of additional accounting rules. These are intended to make the government contracting process efficient and fair and promote the best interest of taxpayers, but they can indeed be challenging to interpret and implement at the start.
Your contract is governed by the Federal Acquisition Regulations (FAR). FAR’s primary accounting concern is cost, especially how costs are allocated and classified. Chief among the allocations are direct and indirect costs, and overhead and general administrative (G&A) costs. It is important to properly define your costs into accurate pools. Not only will this allow you to be compliant with government regulations, but it will also help ensure that you are competitive in bidding on government contracts and profitable in projects you win.
Direct vs. indirect costs
In government contracting, a direct cost is any that is specifically identified with a particular final cost objective (FAR 2.101). To determine this, ask if the cost would be incurred even if the specific contact did not exist. If the answer is no, then it is generally a direct cost. These typically include costs related to labor, subcontractor expenses, materials, and travel.
Indirect costs, on the other hand, are not directly identified with a single final cost objective, but rather with two or more final cost objectives or with at least one intermediate cost objective, such as utilities, rent, insurance, and depreciation.
Indirect costs are accounted for in various pools. The totals of those cost pools are then allocated to each contract. In most cases, your company will create cost pools for fringe benefits, overhead, and G&A. Overhead cost pools will sometimes be spilt out further to allocate home office and field employees. Other common cost pools include material handling and subcontractor handling pools.
It is important to note that the number and composition of cost pools are determined by the contractor, not through government regulations. This is up to you, so know that fewer pools can make it easier to monitor rates and keep administrative costs down, but more cost pools can lend you a higher degree of financial accuracy and transparency.
Overhead vs. G&A costs
It can be difficult to differentiate overhead and G&A cost items, especially in small businesses where owners and employees wear many different hats.
Overhead costs are often referred to as contract support. They support a specific operation or function of the company (but not the entire company) and are usually related to a group of projects (but not one specific contract). A good rule of thumb is to say that an overhead cost exists because your company has billable work; if you had no billable work, you would have no overhead costs. Examples include the cost of obtaining security clearance for employees and a proportionate share of facilities costs, such as rent and office supplies.
G&A costs are those that are necessary to the overall operation of the business. They are necessary to run a business, whether you have billable work or not, and typically include executive costs, legal and accounting fees, IT services, and a proportionate share of facilities costs.
Generally, if an employee usually charges his or her time to direct labor, then the indirect expense would be allocated to overhead. If an individual charges time to G&A, then his or her indirect expenses would be allocated to G&A.
How we can help
Several costs contain characteristics of both overhead and G&A and can be allocated proportionately across both cost pools. CLA’s government contracting team can help identify these costs and determine the best methodology for segregating them into the proper cost pool so they are accurately reflected in your rates.