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Proper Cost Pools

Jan 31, 2020

The second segment of Determining Overhead Rates in Government Contracts breaks down Proper Cost Pools. In order to calculate overhead rates, proper cost pools must be established within a government contractor’s accounting system. This means segregating costs into direct, indirect, and unallowable cost pools.


Anthony Faugno: The basis for calculating the indirect rates is establishing proper cost pools within your accounting system. The objective of proper cost pools is to maximize cost recovery. The cost pools, segregate costs using the company's chart of accounts into the direct, indirect – which indirect is broken down into many different subcategories and we’re going to talk about a few examples of those – and also unallowable costs need to be identified and in a separate cost pool. One issue that I had one time with a government auditor and it was on a pretty decent sized, large company. They were using the term “materials” in their chart of accounts but not “direct materials”. And believe it or not, the government auditors took issue with that so when you're naming accounts within your accounting system, you have to be as specific as possible.

And for instance, indirect, if you have a bunch of accounts under indirect, you can either call them indirect, say fringe or indirect rent or indirect. But generally what we usually do is we would separate the indirect in the chart of accounts into say, a fringe pool and then accounts within there would all be identified as fringe benefits or a G&A pool so that they're all identified under G&A. So we want to have a logical and organized chart of accounts to track your costs. So generally investing some time and a little money up front to get this right pays dividends down the road to avoid major issues.

Direct costs. Direct costs are a cost that can be identified with a final cost objective. Remember we talked about in the beginning what a final cost objective is so a direct cost would be, for instance on a particular contract, you might have direct labor. That's an obvious one, but you might have things like supplies that are identified or materials identified with a specific contract would be a direct cost. It's not limited to items incorporated into end product, like materials and labor. It could be things like consultants or travel expense, subcontractors or other things directly related to that particular contract. Direct costs, they must be segregated further on a contract by contract basis. James talked about that in the requirements of an accounting system and that's the job costing element and it has to be broken down even further on a particular contract where you might have several task orders or CLINs as they call them, contract line items.

You have to basically track your costs by funding level. One way you could look at a direct cost is if you didn't have the contract, would you still incur the cost? Let’s get through a couple of questions here. Let me just go through them. Do the costs need to be charged at the CLIN or the task order level? They do, they need to go down to the specific, wherever there's a funding limit, that's where you have to charge, you have to track the costs at that level. So if you have a task order with CLINs underneath it, then you have to separate, those are separate jobs basically in your job costing. What about depreciation? Is it allowable?

Depreciation is an allowable cost and that must be on a GAAP basis. You cannot use tax methods, accelerated or bonus depreciation methods. It has to be in accordance with GAAP financial reporting and it's allowable. Generally it's an overhead cost, however, it can be a direct cost if it's a specific, say, piece of machinery for specific contracts. And I've actually seen where the government will come in and walk through and say, all right, you have idle capacity in this plant or there's equipment that you're taking depreciation on but it's not being used. Then there's times that the government will look at your depreciation and say, we're going to disallow it because it's not benefiting the government and it's not meeting some of the requirements of the allowable cost. So they may actually try to disallow some of your depreciation. So that's something to be aware of.
Indirect costs. Indirect costs are costs that cannot be identified with a final cost objective or say a specific contract or grant. Indirect costs must be allocated using a logical, consistent method. I talked about having your chart of accounts organized logically and that helps a lot in tracking indirect costs. Methodology must be applied consistently. Properly assign indirect costs to the correct cost pools. So you have to make sure your general ledger postings, they should be reviewed monthly to make sure everything's posted into the right accounts because you don't want to mix up your indirect pools, especially you're unallowables. You don't want those to get into an allowable cost because there's penalties for that. And it allows for cost recovery of operation costs not associated with specific jobs.

So for all of your indirect costs, the reason for calculating the rates is you want accurate rates so that when you're bidding jobs, you can recover as much of your costs as possible for profitability of the company. One other important point of about indirect cost is no two companies are the same.
James Seary:Just on that point about the logical and consistent method…if you're new to setting this up and you're thinking about getting into government contracting, a lot of times you have to think of where you are today and where you're going to be in the future. Because once you set these up, it's not that you can't ever change and add a pool or change your methodology, but it's not an easy thing to do and it also creates some issues with contracting.

If you bid something one way and then you end up changing your methodology and it's going to cost the government more based on that changed methodology, often times that becomes disallowed. So as you set this up, you don't have to be oversimplified but you don't have to be complex for the sake of being complex. And I think when we walk through some of the examples at the back later in the presentation you'll see what I'm talking about. That the recovery is always the same, it's just the complexity to get there and is there really a good business purpose for making those additional amounts of pools and adding the complexity and that’s something a business should think about.
Anthony Faugno:These are just examples of some indirect cost pools. Segregation of indirect cost pools. Fringe benefits is a common one. You've got manufacturing or engineering overhead, site or field operations overhead – if you’re doing work on a government site, generally that rate's going to be lower than your company general overhead rate because you're not using your rent or your phones or other things if you've got people on a government site. So generally a company can do a lot of government site work where government would require it and it makes sense to probably have a government site or a client's site rate. A general administrative rate is also a common cost pool we see. So that would cover things like the corporate finance, executive offices, some legal and also part of the G&A is your bid and proposal costs and your IR&D, which is your internal research and development costs – the non-funded research and development costs, non-funded by a grant or contract.

Unallowable costs – an important cost pool. It's important because the government wants to make sure that you're able to track your unallowable costs in your general ledger so that these costs do not get commingled with the allowable costs. They get real excited about unallowable costs if they find they’re being charged to the government and there are significant penalties if they are being charged. So the FAR part 31.205 lists a whole bunch of unallowable costs. Some examples are bad debts, contributions, some relocation, relocation costs of an employee if they leave in less than one year, alcoholic beverages are unallowable. So it's very important to segregate these costs and show the government, demonstrate that you are tracking these and not charging those in your overhead rates.

This chart is just an example, a kind of summary of how your chart of accounts might be and the expenses. You would have your direct, as you can see on the chart. And then you might, just as an example, it has three contracts. So all your direct costs are tracked by those three contracts. And you have your indirect costs and under that we've got fringe, overhead, G&A and unallowable. And a G&A could have some sub pools also like subcontractor and material handling. Cost of money is a pool that basically is interest charges and could get very complicated. It's usually more in businesses that are more capital intensive type businesses. So that's an example of how a chart of accounts might flow.

This chart, this is just a piece of a chart that we'll be glad to email anybody if they request it, but basically this is a summary of FAR 31.205 with all the costs in it and it tells you if they're allowable or allowable with restrictions or unallowable and it also give you the code number, the FAR reference number that you can Google that if you needed more detail. So we would be glad to send this out. If anybody would like it, they can just email us. We'll get it out to you as soon as possible.

Basic Requirements of a Government Accounting System

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FAR Part 31 – Cost Principles & Procedures

This video from our series Determining Overhead Rates in Government Contracts explores some basics of FAR Part 31, the specific section of the government regulations that details cost principles and procedures.

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As a federal government contractor, your overhead rate is essential to maximizing cost recovery. This video series provides an overview of the elements that come into play when structuring overhead rates, and presents examples of how to calculate overhead rates.

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Anthony J. Faugno

Anthony Faugno is Partner-in-Charge of the firm’s Federal Government Contracting Group assisting clients in complying with the government accounting regulations related to their federal contracts/grants for closely held and family owned businesses.

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