Government contractors typically allocate their indirect costs in one of three pools: fringe benefits, General and Administrative (G&A) costs or overhead costs. Overhead costs are costs incurred in support of the contract, but not directly related to the contract. These costs capture the indirect labor, trainings, travel and certain portion of the shared expenses such as rent, utilities and supplies.
When overhead costs are combined with G&A costs, they form the indirect cost pool, which is the largest cost pool for any government contractor. Therefore, it is important for businesses to be aware of the errors that can be made in reporting these costs. In this article, we identify six common mistakes in reporting overhead costs and advise on how your business can avoid them.
1. Improper segregation of overhead costs in the chart of accounts
Many businesses do not properly define their cost pools in the chart of accounts. The expectation is that the chart of accounts is established based on the three-pool approach, with each cost type grouped into a separate pool: fringe, overhead or G&A. Section 31.203(c) of the Federal Acquisition Regulation (FAR) requires that indirect costs be accumulated by logical cost groupings with due consideration of the reason for incurring such costs. Adopting this requirement will allow for a quicker rate calculation, as well as an easier review of the costs in either pool, especially regarding allowability of costs within a government contract. Stay tuned for an upcoming article on the importance of G&A rates.
2. Improper allocation of overhead costs
With the knowledge that overhead costs are costs in support of contracts, it is important for costs that fall within this category to be allocated as overhead costs. These costs should also be allowable, reasonable and allocable as defined in FAR 31.201-2, 3, and 4. We have noticed that some businesses struggle to properly assign these costs to pools, especially when differentiating overhead from G&A costs and allocating expenses accordingly. They tend to err on the side of caution, thus understating their overhead rate and overstating their G&A rate. We understand that the categorization of expenses is not always easily defined, so it is imperative for businesses to implement targeted training and adopt established policies on expense allocations.
3. Inconsistent treatment of costs
A common mistake we have seen among businesses is allocating recurring expenses to different cost pools each time. For example, a business might allocate an expense as “direct” the first time and “indirect” the next time; or perhaps “overhead” the first time and “G&A” the next time. In most cases, each cost belongs to a specific cost pool and as such should not be allocated to more than one cost pool.
Another common error is when businesses charge expenses directly to a contract without eliminating the same costs from the indirect cost pools. This is referred to as “double counting” costs, according to FAR 31.203(b). This issue usually happens when a new allocation of costs is targeted in a new contract or proposal, but the change is not carried to the costs incurred on other contracts when calculating the rates.
4. Inconsistent allocation methodology of shared costs
This common mistake addresses both consistency in methodology used in proposals to be carried over to actual expenses, as well as consistent methodology in allocating shared costs over time. For example, businesses might have challenges with allocating rent on indirect labor and square footage. For more information, refer to Cost Accounting Standard 401.
5. Improper management and allocation when using several overhead cost pools
Most small business will have one overhead cost pool, but it is common for some to have more than one to differentiate between activities. An example of this situation could be engineering vs manufacturing. With more overhead cost pools, the visibility of data increases, which assists management in making business decisions. However, keep in mind that having more than one overhead cost pools also increases the likelihood of misallocation of expenses between pools. Refer to common mistake 3 to learn why this can be problematic.
6. Improper management of costs
Like any other costs, overhead costs must be monitored regularly. However, monitoring any indirect costs is more difficult due to the shared responsibility of incurring them. While direct contract costs are usually managed by one or two contract managers, indirect costs are typically incurred by several individuals, which makes monitoring them harder to manage. Indirect costs also tend to fluctuate monthly, though some are more predictable than others (for example, monthly rent). If businesses do not review these costs regularly, they run the risk of missing errors or inefficiencies that could affect their indirect rates. These must be addressed in a timely manner because increased rates due to an increase in overhead costs can potentially lead to decreases in profitability or competitiveness.
It is essential for businesses to recognize these common mistakes and establish processes to mitigate them. For guidance specific to your business, contact our experienced government contractor team today.