Government Contracting: difference between Direct Cost and an Indirect Cost?

The FAR clause 31.201-1 reads, “The total cost, including standard costs properly adjusted for applicable variances, of a contract is the sum of the direct and indirect costs allocable to the contract, incurred or to be incurred, plus any allocable cost of money pursuant to 31.205-10, less any allocable credits. In ascertaining what constitutes a cost, any generally accepted method of determining or estimating costs that is equitable and is consistently applied may be used.”

Shoot.. I’ve done this a long time and even I find that a bit confusing.  Let’s break this down into something a bit more simple.

In a compliant DCAA (Defense Contract Audit Agency) accounting system, you need to create multiple “pools” of costs.  Think of the pools as piles of receipts… you could pile them all into one box or you could file and sort them into a filing cabinet.

Now imagine that filing cabinet had three drawers and then various folders within each drawer and the costs were segregated by the type of cost.  That would make it a lot easier to both find particular receipts later and also allow you to make better budget decisions because you would know exactly how much you spent in each category.  So besides being compliant with DCAA, it is also good business sense.

So, a simplified look at our filing cabinet would look a little like this:

  • Drawer 1 – Direct Costs
    •  Folder 1 – Labor
    •  Folder 2 – Travel
  • Drawer 2 – Indirect Costs
    • Folder 1 – Administrative Labor
    • Folder 2 – Overhead Travel
    • Folder 3 – Rent
    • Folder 4 – Utilities
  • Drawer 3 – Unallowable Costs

We will talk a bit more about Unallowable costs in another blog post but what are the differences between Indirect and Direct Costs?

A Direct Cost is something that can be charged “directly” to the contract.  For example, if you are a services company and you have sold the government hours of a Software Engineer’s time, the cost of paying that person’s hourly rate is a direct cost.  If you pay him $50/hour, that amount is a Direct Cost.  Any travel that was authorized by the client to be charged would also be a Direct Cost. So for example, if the client asked him to visit another site that requires a flight to visit, the cost of the flight and hotel and car would likely be a direct cost (if it was approved under the contract).  Commuting costs are not allowed, however, to be charged.

But that is not the only cost of employing that person.   Someone needs to process his timesheet and payroll, you need to pay for office space for him to sit, a computer for him to work, etc.  The costs that are necessary to provide the service or product to the government but are not directly billable are called Indirect Costs.

Both Indirect and Direct Costs are considered Allowable costs and are charged to the government but just in different ways.  Direct Costs are charged at what it cost you and Indirect Costs are charged by applying a % to the Direct Costs.  The % cost is created by combining your Indirect Costs into a “pool” that you then divide by your total labor costs across all your contracts.   You can read more about how to develop your total rate to charge to the government in my blog, Developing Rates for Government Contracts.   In general though, your invoice to the government would look a bit like this (assuming an Indirect Cost of 80% and a Fee of 7%):

Labor CategoryDirect CostIndirect Cost (80%)Fee/Profit (7%)Total Cost Per Hour
Software Engineer$50$40$6.30$96.30

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