One of the biggest issues in Government Contract Accounting is the identification and segregation of costs. It’s a make or break separation that is at the core of Government Contracting. These are fairly simple but can get rather confusing and must be as natural to your accounting team as feathers on a bird.
Two main types of costs that your accounting team needs to know are direct and indirect costs. Let’s look at their definitions through the authority in the matter— The Federal Acquisition Regulation.
Here are FAR 2.101 Definitions:
- Direct cost means any cost that is identified specifically with a particular final cost objective. Direct costs are not limited to items that are incorporated in the end product as material or labour. Costs identified specifically with a contract are direct costs of that contract. All costs identified specifically with other final cost objectives of the contractor are direct costs of those cost objectives.
- Indirect cost means any cost not directly identified with a single final cost objective, but identified with two or more final cost objectives or with at least one intermediate cost objective.
That’s such a huge read!
Obviously, for the uninitiated, it seems very complicated at first glance. Let’s trim the fat and make it simpler, with a very fun example.
Let’s say you are back to when you were a kid, school is out and you’re making the most out of your vacation time and put up a small and simple juice stand with your friend. You make apple juice, grape juice, and orange juice for the public. Now, here comes your dad asking you to make him a special big batch of lemon juice that he will bring to his office meeting. He’ll be paying you a good amount for this and you say “yes” and feel great. Here, you and your friend make up the Company. Your Dad is the Government, and the lemonade order is the Government Contract. Here comes the accounting–
It’s time to identify and separate your costs. What’s your direct cost? The lemons and the juice containers are your direct costs because they tie directly to the product that was contracted to you, the lemon juice.
If your friend does work solely on the lemon juice, that labour will be part of the direct cost. If you and your friend decide to work on all the juices, your labour cannot be part of the direct cost! See how it may get confusing?
The same idea would be if you purchase or use a separate juicer just for the lemon (direct cost) or used the same juicer (indirect cost) that you are using for all the juices. If you are using an electric juicer for all the juices, that electricity expense will also be indirect.
If you are on your lawn, and your mother asks you for rent on your juice stand (what a mom!) before the lemonade order, that rent is indirect. If she only charges you when the lemon order came in and will not charge you after the lemon order is done, that cost for rent can be connected to the product and becomes a direct cost!
Of course, this is oversimplified and is just a teaser so you can tell direct costs from indirect costs. There are a lot of minute differences between the two and some costs can somewhat blur the lines. This is where your Government Contract Accounting experience comes in. An accountant with the right training and experience can easily identify and sort these costs to their rightful place using the right tools, the proper regulations and ample experience.
Don’t worry, if you get caught in the perplexing world of costs in Government Contract Accounting. Leave it to the people in the know. Focus your attention on your Government Contract, leave the accounting to us. Sign up for a free consultation now!