With Summer in full effect, what a perfect time to talk about building pools – cost pools, to be exact. To develop an indirect cost rate structure, costs must be segregated into homogenous pools where the allocation measures for indirect cost are based on the beneficial or causal relationship between an indirect cost pool and cost objectives. To best introduce the concept and importance of pooling costs and the most common categories related to government contracts, it is best to visualize an example that breaks down the components that define this niche industry.
The example below allows us to explore the types of cost allocations and their differences in simple terms. It’s time to examine the curious case of building our indirect cost pools.
At the inception of our example, let us play the role of the pool company. We are awarded a contract to build a beautiful in-ground pool for a family with a pre-determined, set budget to adhere to. The family here plays the role of the government, and they will scrutinize the bill while tediously looking to optimize the results, minimize unnecessary costs, and eliminate unallowable costs.
The Three Categories of Pooling Costs
At the beginning of this ambitious pool project, we come across the first category of pooling costs – Direct Costs. In simplest terms, direct costs are the inputs traced to the cost object: the finished pool. Examples of these direct costs include direct labor, direct materials, design costs, inspections, excavation, and all other costs linked to completing the pool.
With your pool designed and approved, we run into the second category of cost pools – Indirect Costs. Indirect costs are those expenses not directly identified with a single, final cost objective but are identified with two or more final cost objectives or an intermediate cost objective. In simpler terms, indirect costs can not be traced to a single project but are incurred for joint benefit. The most common indirect costs are:
- Fringe-related expenses (expenses paid by the company on behalf of employees).
- General administrative expenses (inherent cost of operating a business).
- Overhead expenses.
When these costs are added to the customer’s bill, expect to perform a deep dive to ensure the costs are being properly categorized.
As the days of construction grow long and wearisome for the laborers, we encounter the final category of costs – Unallowable Costs, which are typically a subcategory of the indirect costs. Unallowable costs are costs that are expressly unallowable based on FAR Part 31, are never billable and cannot be included in the indirect cost pools. For example, renting construction equipment is allowable, but costs incident to major repair and overhaul of rental equipment are unallowable – meaning these costs are never billable and cannot be included in the indirect cost pools.
- Another common example of unallowable costs is bad debts, including actual or estimated losses arising from uncollectible accounts receivable due from customers and other claims, and any directly associated costs such as collection and legal costs.
- A directly associated cost is any cost generated solely due to incurring another cost, and that would not have been incurred had the other cost not been incurred. When an unallowable cost is incurred, its directly associated costs are also unallowable.
Let us take a moment to dry ourselves and recap the three categories introduced in the pool example. As highlighted above, it becomes clear that identifying costs and strategically organizing them early on plays a critical role in the billing process. It is important for the companies to structure their general ledgers and accounts to clearly identify the costs related to the contracts and the associated sub-projects. Ultimately with Government Contracts, the specificity of your allocations and your organization of the projects as it relates to contracts can allow government agencies to achieve more affordable programs, control costs throughout the project lifecycle and enhance efficiencies by understanding the exact type of associated costs with the projects and contracts awarded. Understanding rates is important during the bid/no-bid decision process and when pricing the bid. As a result, it allows a contractor to gauge whether they can price competitively or if they are out of market and if they can price competitively and yield favorable returns.