Understanding Direct Costs, Indirect Costs & Cost Pools

Summary of  Keypoints

• Direct and indirect cost segregation is required by FAR and enforced by DCAA, ensuring that costs are consistently classified and properly charged to government contracts throughout the contract lifecycle.
• Direct costs are those clearly attributable to a specific contract, such as contract-specific labor or materials, while indirect costs support multiple contracts or overall operations and cannot be practically traced to a single cost objective.
• Consistent treatment is critical, as FAR allows certain minor costs to be treated as indirect for practicality, but only if applied uniformly across all contracts and accounting periods.
• Indirect costs are grouped into cost pools and allocated using defined bases, most commonly Fringe, Overhead, and General & Administrative (G&A), with allocation rates calculated by dividing total pool costs by their respective bases.
• Proper cost segregation supports compliance and accurate pricing, helping contractors pass DCAA audits, establish reliable indirect rates, and produce accurate budgets and forward pricing estimates.

Department of Defense (DoD) contractors are required by the Defense Contract Audit Agency (DCAA) to separate direct and indirect costs throughout the terms of their contracts. Federal Acquisition Regulation (FAR) sets the standards for what is considered a direct and indirect cost.

To segregate direct and indirect costs, contractors must first understand the distinction between them. Here we take a closer look at the differences between direct and indirect costs and why their separation matters, as well as indirect cost pools and how they function.

Direct Costs

FAR defines direct costs as those that can be directly associated with a final cost objective, such as a contract. An example of a direct cost would be materials purchased specifically for a contract or labor costs associated with performance on a contract. 

Another way to identify direct costs is to consider whether the expense would be incurred if a given contract were not awarded.  Direct costs can always be directly connected to a given contract.

Some DoD contractors find it impractical to isolate and record small or inconsequential costs specifically to a government contract. Consider the cost of screws, for instance, which may be used for multiple contracts.  Tracking the cost of each individual screw to the contract for which it was used could be unworkable.  In such cases,  direct costs may be considered indirect for insignificant amounts, as long as the treatment is consistent.

Indirect Costs

Indirect costs are those that cannot easily be associated with a specific contract. These may be costs that can be linked to two or more cost objectives or even an intermediate cost objective.

An example of an indirect cost might be the expense of Wi-Fi used to fulfill government contracts. Although this is a legitimate expense, it cannot practically be tied to one specific contract.

If a contractor uses office space to perform work or otherwise fulfill a contract, this would also be an example of an indirect cost. However, if the contractor rented and used the office space exclusively for the purposes of a single contract, then it would be considered a direct cost.

Since indirect costs can make up a significant portion of a proposal, DCAA reviews these costs and their separation from direct costs closely during the auditing process.

Why These Costs Need to Be Distinguished

FAR requires government contractors to segregate direct and indirect costs and maintain an accounting system that applies consistent criteria to reliably segregate these costs. The same is true for labor distribution systems—the system must segregate direct and indirect labor and apply the corresponding cost to direct objectives or indirect cost pools.

While cost segregation is essential for compliance with FAR and contract terms, it is also integral to estimating accurate forward pricing rates and budgets for the fiscal year. 

Indirect Cost Pools

Grouping indirect costs with similar bases into cost pools allows contractors to appropriately allocate the costs to cost objectives. Each pool of costs is allocated according to its allocation base.  For instance, an overhead pool of $5M allocated over a base of $15M creates an allocation rate of 33%, calculated by dividing the total amount of the cost pool by the allocation base.

The most common indirect cost pools are Fringe, Overhead, and General & Administrative costs, which are comprised of costs as follows:

• Fringe. These costs include those related to employees, such as paid leave, health insurance, and payroll expenses.
• Overhead. Overhead costs include those that make daily operations possible. These are costs that can be directly tied to more than one contract. An example of an overhead cost would be machinery used for several contracts. 
• General & Administrative (G&A). Any expenses that are necessary for a contractor to run their business are considered G&A expenses. These are expenses that are not associated with contracts but are necessary for operating the business. These could be expenses such as IT security and accounting.

DCAA also identifies an unallowable cost pool, which separates indirect costs from unallowable costs to ensure these costs are not charged to contracts along with indirect costs.

Contractors preparing for a pre-award survey with DCAA should ensure indirect costs are properly allocated to their respective cost pools..

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