CHAPTER 5
Other Direct Costs
This chapter provides guidance on estimating other direct costs. The term other direct cost commonly refers to direct costs other than direct labor. For contracts where materials, subcontracts, consultants, or equipment are significant, other direct costs may be used as a term to apply to less-significant items such as direct travel, supplies, and overnight mailings. The first portion of this chapter addresses costs to be considered direct (as opposed to indirect). The second, and very brief, portion addresses the estimation of these costs.
ESTABLISHING OTHER DIRECT COSTS
Contractors with established cost accounting systems can go directly to the estimating process. Others will have to consider which costs will be direct and which costs will be indirect. The remainder of this section provides guidance on these decisions.
Basic Concepts
The Federal Acquisition Regulation (FAR)1 states:
No final cost objective shall have allocated to it as a direct cost any cost, if other costs incurred for the same purpose in like circumstances have been included in any indirect-cost pool to be allocated to that or any other final cost objective. Direct costs of the contract shall be charged directly to the contract….
This definition of direct costs is not as pointed as the Cost Accounting Standards (CAS) definitions: “Direct cost means any cost which is identified specifically with a particular final cost objective….”2 and CAS 9904.418-30(2) continues this requirement:
Direct cost means any cost which is identified specifically with a particular final cost objective. Direct costs are not limited to items which are incorporated in the end product as material or labor. 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.”3
The concept of direct and indirect costs embodies safeguards to avoid inequitable cost allocations that would result if costs incurred for the same purpose, under like circumstances, were charged directly to some cost objectives and indirectly to others. Both the FAR and the CAS address this requirement. The FAR states4: “All costs specifically identified with other final cost objectives of the contractor are direct costs of those cost objectives and are not to be charged to the contract directly or indirectly.” The CAS definition of direct costs states5: “All costs identified specifically with other final cost objectives of the contractor are direct costs of those cost objectives.”
This concept is reinforced by CAS 402-40, Consistency in Allocating Costs Incurred for the Same Purpose,6 which has a fundamental requirement that
All costs incurred for the same purpose, in like circumstances, are either direct costs only or indirect costs only with respect to final cost objectives. No final cost objective shall have allocated to it as an indirect cost any cost, if other costs incurred for the same purpose, in like circumstances, have been included as a direct cost of that or any other final cost objective. Further, no final cost objective shall have allocated to it as a direct cost any cost, if other costs incurred for the same purpose, in like circumstances, have been included in any indirect-cost pool to be allocated to that or any other final cost objective.
The FAR has a similar provision regarding what is called double counting or double charging7: “All costs specifically identified with other final cost objectives of the contractor are direct costs of those cost objectives and are not to be charged to the contract directly or indirectly.”
The key words in applying CAS 402 are costs incurred for the same purpose in like circumstances.8 CAS 402 contains an illustration of when costs appear similar, but are not incurred for the same purpose:9
Contractor proposes to perform a contract which will require three firemen on 24-hour duty at a fixed-post to provide protection against damage to highly inflammable materials used on the contract. Contractor presently has a firefighting force of 10 employees for general protection of the plant. Contractor’s costs for these latter firemen are treated as indirect costs and allocated to all contracts; however, he wants to allocate the three fixed-post firemen directly to the particular contract requiring them and also allocate a portion of the cost of the general firefighting force to the same contract. He may do so but only on condition that his disclosed practices indicate that the costs of the separate classes of firemen serve different purposes and that it is his practice to allocate the general firefighting force indirectly and to allocate fixed-post firemen directly.
Other direct and/or indirect costs also present a need for analysis to determine whether the costs are incurred for the same purpose or for different purposes, thereby ensuring that costs incurred for an ostensibly identical purpose are not charged inconsistently (i.e., direct at one time and indirect at another time), but rather as different costs. These situations include tooling costs (general tooling vs. special tooling), security costs (general guard services vs special facility guard services), training costs (training of benefit to all contracts vs training required by contract or relevant to only one contract), software (common-use software versus special-purpose software required by contract or relevant to only one contract) and meeting costs (general meetings vs contract-specific meetings).
One practical approach to the identification of direct costs is the “but for”10 rule. If a cost would not have been incurred but for the contract, this is an indication that the cost might be properly considered a direct cost. Conversely, if the cost would have been incurred even if the contract did not exist, this is an indication that the cost might be properly considered an indirect cost. The caution here is that this approach basically uses a causal approach to cost allocation. Often a beneficial approach can be more appropriate. A classic example in ascertaining whether a cost should be addressed as a direct or indirect cost, using either the causal or the beneficial concept, is that a specific government contract caused the company to install a security fence that benefited all company work due to increased security. In practice, the benefit concept generally wins out over the causal concept.
Both the FAR and the CAS incorporate a materiality aspect to these definitions. The FAR11 provides:
For reasons of practicality, the contractor may treat any direct cost of a minor dollar amount as an indirect cost if the accounting treatment—(1) Is consistently applied to all final cost objectives; and (2) Produces substantially the same results as treating the cost as a direct cost.
The CAS address this topic in terms of blanket costs.12 An example of a blanket cost is product inspection labor. Often this labor is incurred for many cost objectives in small increments of hours that make recording labor specifically to a contract burdensome. Although the CAS describe blanket costs as being reallocated to final cost objectives as direct costs, in practice such costs are often allocated as part of an indirect-cost pool. For example, miscellaneous small-part costs might be included in the material-handling cost pool. Generally, this approach is accepted if the allocation base is valid.
Precision versus Practicality
Extensive classification of costs as direct rather than indirect inarguably results in a more precise allocation of costs to cost objectives. However, those advocating extensive direct-cost categorizations foster a “tunnel vision” approach that ignores the impracticality of classifying and actually recording such costs as direct. The impracticality results from the administrative efforts required to categorize the cost as direct—often with no impact on ultimate cost allocations and at significant administrative expense.
For example, it is a common perception that the government requires more reproduction of documents than do commercial clients. Therefore, rather than include all document reproduction costs as indirect, to be allocated proportionally to both commercial and government work based on direct-labor dollars, allocating reproduction costs based on which job requires the copying would more precisely be done on the basis of the reproduction costs applicable to the cost objectives.
However, the recordkeeping required to identify numbers of copies to a cost objective is not as simple as it may appear. To allocate reproduction costs equitably, several requirements are obvious. First, a contractor must collect all the cost of reproduction. Identifying all such costs can be difficult if the costs consist of labor to make copies, the paper costs, the equipment costs, and so on. Second, all employees must diligently record copying efforts either by contract or by indirect functions or cost center. And, of course, a contractor must have a reasonable means of estimating such costs in a proposal.
Too Much Information
Direct costs frequently attract the attention of customers who do not want to pay for such items as direct charges or at all. For example, if reproduction costs are charged direct, a customer might object to these costs being considered direct or perhaps disagree with the volume or even unit price for reproduction costs in a contractor’s proposal. This situation often results in more extensive price negotiations. Frequently, a contractor must concede these costs during negotiations, since such costs are often viewed by some contracting officers as indirect only; such a perception often results in a negotiated fixed price that does not sufficiently cover these direct costs. The source of these perceptions may be based on limited knowledge of accounting and FAR cost principles or a contracting officer’s prior experiences and is simply a means to lower the price on a specific contract. Often, some contracting officers will tend to cherry-pick a contractor’s other direct costs and attempt to exclude items not considered pertinent to their contract.
Costs that Generally Are Indirect
The proceeds from the sale of scrap and salvage are more commonly credited to indirect costs rather than credited directly to individual contracts. This position is likely due to materiality and the administrative burden of tracking these items by individual cost objective. In some instances contractors record scrap sales as “other income.” This is an improper handling of the transaction, which should be credited to the applicable cost objectives through an appropriate indirect account.
The vast majority of companies record purchasing and contract administration as an indirect cost. This is likely due to the fact that, although the costs of these functions for large contracts can readily be identified as direct, smaller contracts often require significant administrative efforts to record purchasing and subcontracting time spent as direct costs for these functions.
Training and computer operations generally are recorded as indirect. Computer operations are even more likely to be recorded as indirect because mainframe computers for engineer and design work have generally been replaced by desktop computers with broader capabilities than the mainframes had.
The cost of overnight mailings, courier services, long-distance telephone calls, cell phones, facsimile messages, copying, automobile mileage, software, supplies, office space, and similar items are generally charged indirect even though these items could be identified to specific cost objectives. Such functions would require significant administrative effort to allocate directly to cost objectives.
Costs that Generally Are Direct
Freight in and out, design engineering, drafting, shift premium, preproduction costs, line inspection, travel, packaging and preservation, royalties, warranty, rework, and scrap work are generally charged direct. The decisions in any instance identifying these costs as direct are most likely influenced by the materiality of such costs.
For warranty costs, the Defense Contract Audit Agency (DCAA) audit guidance acknowledges that these costs may be (consistently) recorded either direct or indirect. Reviewers are advised:
When warranty costs are included in overhead, the auditor should determine that the base for allocating this expense is made up only of contracts containing warranty provisions. When evaluating direct charges to a contract for warranty costs, the auditor should ascertain that the same type of costs incurred on other Government or commercial products are excluded from allocable overhead unless it is clearly established that a cost duplication does not exist.13
Costs that Predominantly Are Direct
Other costs that are almost exclusively charged as direct costs include subcontracts, trade discounts, refunds, and allowances on purchases; purchased labor (on-site and off-site); and special tooling and test equipment. A contractor must ensure that any discounts, refunds, and allowances are credited correctly and not booked as other income.
Costs with No Clear Consensus
Several costs have found no clear consensus on direct or indirect charging. These costs include overtime premium, cash discounts, incoming material inspection, inventory adjustments, and holiday differential.
ESTIMATING OTHER DIRECT COSTS
Estimating other direct costs depends on whether the cost is a purchased item or an in-house expense. Depending on its nature, the cost is estimated either (1) like any purchase of materials and services or (2) like any in-house labor with applicable indirect costs.
CURRENCY EXCHANGE
Currency exchange must be considered in pricing fixed-price and time-and-materials contracts. Contracts are almost exclusively written in US dollars; thus, the risk in currency fluctuations will be with the seller. This situation justifies more profit due to the additional risk. Published exchange rates should be used to convert non-US payments into US currency. For cost-type contracts, any contract obligations to vendors are to be converted to dollars at the time of payment; thus, the risk is reduced substantially. Currency exchange pricing can be either direct or indirect.
BASIS OF ESTIMATE
The quantities and prices estimated must be documented as to source of estimates. A form for other direct costs is provided in Illustration 5-1.
Notes
1. FAR 31.202(a).
2. CAS 9904.402-30(3).
3. CAS 9904.418-30(2).
4. FAR 31.202(a).
5. CAS 9904.402-30(3).
6. CAS 9904.402-40.
7. FAR 31.202(a).
8. Defense Contract Audit Agency Contract Audit Manual 8-402(b).
9. CAS 9904.402-60.
10. Leon B. DeLong to DeLong Engineering & Construction Co. v. United States, 146 Ct. Cl. 289, 175 F. Supp. 169 (1959).
11. FAR 31.202(b).
12. Preamble to original publication; May 15, 1980.
13. DCAM 7-1604.
ILLUSTRATION 5-1: Basis of Estimate for Other Direct Costs