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Passing your Pre-Award Survey – Segregating Direct & Indirect Costs

Over the past few years, we have seen a dramatic increase in the number of solicitations requiring a contractor to have an “approved accounting system”. A recent example is the draft Request-For-Proposal for the CIO-SP4 Contract, which requires contractors to maintain an adequate accounting system. We have also seen more and more large prime contractors pushing this requirement down to their subcontractors. For smaller contractors, this means that at some point, there is a good chance they will need to go through a Pre-Award Survey of Prospective Contractor Accounting System performed either by the DCAA, another cognizant agency, or an independent CPA firm. Although this may seem like a daunting task for smaller contractors, it is a manageable undertaking with proper guidance. Simply put, the review is going to look at whether your accounting system, policies, and procedures are designed and functioning properly to comply with requirements set forth by government contracting regulations.

To assist with preparing for a survey, we are going to review in a series of articles the Evaluation Checklist criteria on the Standard Form 1408 (SF 1408), which serves as a guide for helping you prepare for the audit. These articles are meant to serve as a starting point, not a master guide. If this is your first time through the audit process and you lack in-house personnel with expertise in this area, I would encourage you to seek out a consultant to help prepare for the audit. As we go through the Evaluation Checklist, we will also demonstrate a practical example for how to address each item in your accounting system.

In each article we will tackle one of the checklist criteria, and discuss the principles behind the criteria and how to begin putting processes in place and setting up your accounting system in order to meet the criteria. The checklist criteria we will discuss this week is:

2a. Proper segregation of direct costs from indirect costs

FAR 31.202 defines a direct cost as “any cost that can be identified specifically with a particular final cost objective”. For most contractors, the distinguishing factor between a direct and indirect cost is based on whether a cost is directly allocable to a contract. If a contractor employs a Subject Matter Expert, and that employee works on a specific contract and charges their time to that contract, the result is a direct cost of that contract. Alternatively, when that Subject Matter Expert takes vacation or performs administration functions, those hours can’t be directly assigned to any one contract, and is therefore an indirect expense.

There are two key components to bear in mind when properly segregating direct costs from indirect costs. The first component is establishing a method for the costs to be distinguished between direct and indirect based on the source document and any systems in place. The second component is how the accounting system is designed to segregate those direct costs. Most contractors will have some component of labor that is a direct cost. To properly segregate costs, the timekeeping system must allow for employees to record their time to direct charge codes as well as indirect charge codes. Similarly, purchase orders and expense reports should be designed so that employees can specify whether the cost is direct or indirect, and what contract the purchase relates to for direct costs. The second component to segregating direct costs from indirect costs relates to how the accounting system and chart of accounts is set up. The accounting system should have separate accounts for direct expenses vs. indirect expenses.

Putting the criteria into practice in your accounting system

A starting point for meeting these criteria is a properly designed chart of accounts. You want a numbering sequence for your chart of accounts that clearly distinguishes between direct costs vs. indirect costs, and allowable costs vs. unallowable costs. A common method for numbering your chart of accounts is as follows:

5000-5999: Direct Costs

6000-6999: Fringe (indirect)

7000-7999: Overhead (indirect)

8000-8999: General & Administrative (indirect)

9000-9999: Unallowable costs

This design allows for a clear segregation between the different types of costs. To take the example further, instead of having a general “Salary” or “Labor” account, you will likely have a combination of the following accounts:

– Direct Labor (5000 series)

– Holiday, PTO (6000 series)

– Overhead Salaries (7000 series)

– G&A Salaries (8000 series)

– Unallowable Labor (9000 series)

Note how each of these accounts should be within the first numbering sequence to properly segregate the costs. If you are using QuickBooks, you likely will want to classify your 5000 series as “Cost of Goods Sold” for the account type. This allows you to further build in the functionality of segregating direct costs and making a clear distinction between direct and indirect costs. QuickBooks however won’t allow for a further breakdown of account types where you could separate Fringe, Overhead, G&A, and Unallowable. All of those accounts will need to be set up in your chart of accounts as an account type of “Expenese” or “Other Expense”. You can however use parent accounts – for example you can create an account 6000 that is called Fringe Expenses, and then not charge to that account, but have all other fringe accounts as a sub-account of the parent 6000 Fringe Expense account. More robust accounting systems such as Deltek Costpoint & Unanet Financials will give you the functionality to classify an account as direct, fringe, overhead, G&A, or unallowable based on the pools and bases you set up within those systems, but that goes beyond the scope of what we will talk about today, and is certainly not a requirement to meet the checklist criteria being discussed here.

As a final note, it is important to keep in mind that with all the evaluation criteria, to pass the review you must do more than just set up the accounting system properly. Setting up different accounts for direct and indirect expenses is the first step, but there must also be policies and procedures in place, as well as systems and processes built around the accounting system to allow for proper segregation of costs. This requires building a timekeeping system that allows charging to proper categories of labor and specific contracts. In addition, this requires training personnel, specifically accounting personnel, so that they are familiar with the principles of government contract accounting, and can correctly distinguish between direct and indirect costs.

For example, if the CEO of a company is not billable on a given contract, but perhaps they spent their entire day speaking with the CO for that contract and managing their employees on that contract, the CEO may logically think that their time should be charged to that specific contract. This would not be correct though, as they are performing overhead and administrative functions that are not directly allocable to the contract, and should not be charged as such. Personnel must be trained to charge their time properly, otherwise the setup of the accounting software itself to segregate direct and indirect costs becomes meaningless.

Please send an email with any of your questions and look for future articles in the series. Click here to see our services for government contractor accounting.

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