Theory is all fine and good but practical application and what the government considers proper drives this business. So the widely accepted allocation bases are as follows:. Fringe: Total employee labor. This implies that fringe is allocated not only to direct activities but indirect as well.
So in calculating rates, fringe must be allocated to the other indirect cost pools that include labor. This is illustrated in the Indirect Cost Rate Illustrations. Overhead: The most widely accepted allocation base is Direct Labor. Some contractors use the sum of Direct Labor and Fringe. This is technically correct but is only needed if there are multiple fringe pools. In most cases Direct Labor is adequate. However including Fringe in the allocation base is acceptable, it just complicates the indirect cost calculations and application to bases.
Material Overhead Pools — This is common in manufacturing operations where there is significant materials and subcontract, purchasing, inventory activity, etc. It is also seen in construction type businesses.
This overhead pool accumulates the cost of purchasing, subcontract management and inventory activities. Often contractors want to add a material handling charge to materials or subcontracts. This is all fine and permitted by the FAR. However, unless the contractor separately accumulates this cost for audit verification, a contractor cannot propose, invoice or claim this cost.
Applying a material handling rate and failing to accumulate these costs separately is a formula for disaster for sure. In any event, the most commonly used allocation base for Material Overhead pool cost is Material and Subcontract Costs. So to say the least the government is divided and they are not on the same page. This is a problem with no apparent solution in sight.
However see Value Added base discussion below. With all things equal the preferred allocation base is the Total Cost Input base. In this case a cost impact is required demonstrating the inequity. In such cases the value added base is used direct labor and fringe.
The bottom-line is that the allocation base selected must be representative of the entire business activity and must be equitable. Absent some of these exceptions the Total Cost Input base is preferred by the government.
The Indirect cost pools and allocation bases are summarized in the table below. That is the standard and generally accepted indirect cost pools and allocation bases without consideration for unusual situations.
I always recommend getting agreement with the government up front if at all possible. This is not full-proof as auditors and opinions frequently change. But it does hopefully bring some sanity to the process. The worst scenario is to proceed down a certain path without government buy-in and years later have an auditor question your methodology.
So it is always best to get government buy-in as soon as possible and have the methodology reviewed annually versus being faced with a government realization many years later.
Granted a contractor cannot control what the government chooses but it certainly can try. Govt Preferred Allocation Base. Intermediate cost pools are not typically relevant to most small businesses but are applicable to some so I decided to include this discussion. Intermediate cost pools arise when there are service centers present. Any time you have a significant indirect cost that supports other indirect and direct departments or functions may require an intermediate cost pool.
In these cases, an alternate allocation base may be required for this sub-set of overhead. The most common is occupancy or facilities, engineering support or reproduction. To be compliant, these costs need to be accumulated in an intermediate cost pool and allocated using a base that is considered equitable.
The allocation base is either an input or output base. In the case of facilities or occupancy the most widely accepted base is square footage. Functions will be allocated cost based on the square footage of that particular function or space. Fringe Pool:. Overhead Pool. Indirect Cost Explained. A discussion of indirect costs follows: I. Direct vs. Indirect Costing II.
Allocation Bases IV. Intermediate Indirect Cost Pools V. Indirect Cost Rate Calculations I. Indirect Costing The first item that must be mastered is to be clear on the definition of direct cost and indirect cost. The buyer should always know what is the overhead cost and indirect cost included in the product as a percentage of the cost of the product that the manufacturer is considering.
And we will offset the amount in purchase orders. As most of us know, direct costs are costs that can be tied to one cost objective. In making a particular product say a sofa, you will have direct material such as wood, foam, springs, belts, adhesives, and fabric and direct labor that is used in creating that particular product specifically.
For example, for a particular product of a customer firm a specific testing tool to test the quality of the product say load testing of a specific foam only used for one customer is needed. Indirect costs are costs that cannot be tied to one cost objective, but can be tied to multiple two or more cost objectives. Overheads are still costs that support the production of goods in some way. For example, the electricity that is required to run the machines that produce output goods.
Electricity is still some way a direct cost, but not directly producing the good. Overheads are defined as those indirect support costs incurred to support operations or direct production.
These are costs directly related to projects but cannot be identified to one project or contract. A good example is operations management where functions support the overall operation. Back To Insights. Authors Barbara Morgan. Related Industries Government Contracting. Related Services Outsourced Accounting. Expanding What's Possible.
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