Cost Pools

The concept of cost pools is unique to government contracting. Certainly, some smart accountants in other industries organize their chart of accounts. Still, many small businesses use no account numbers or add accounts as they occur with no rhyme or reason to the assigned number.

Cost pools group like types of expenses for ease in calculating indirect rates. Well-organized cost pools aid in data entry when the user can select the 6xxx series when entering fringe expenses without scrolling through the full chart.

FAR 31.203(c) states:

“The contractor shall accumulate indirect costs by logical cost groupings with due consideration of the reasons for incurring such costs. The contractor shall determine each grouping to permit the use of an allocation base common to all cost objectives to which the grouping is to be allocated. The base selected shall allocate the grouping based on the benefits accruing to intermediate and final cost objectives. When substantially the same results can be achieved through less precise methods, the number and composition of cost groupings should be governed by practical considerations. They should not unduly complicate the allocation.”

Cost pools must be homogenous, meaning they contain only one expense. [CAS418] For indirect rates, we are focused on:

  • 5xxx Direct / Cost of Goods Sold (COGS)
  • 6xxx Fringe
  • 7xxx Overhead
  • 8xxx General and Administrative (G&A)
  • 9xxx Unallowable & Other

For example, this organization allows the user to summarize all the fringe expenses quickly and easily without having to identify fringe accounts scattered through the chart.

Primary Cost Pools

All contractors have five primary cost pools: Direct, Fringe, Overhead, G&A, and Unallowable.

Direct

Direct costs (aka the cost of goods sold, or COGS) are those costs easily identifiable to a single final cost objective, such as a contract, project/job, product, or service. The cost objective is known at the time of expense incurrence and is accordingly assigned. Costs attributable to two or more cost objectives are indirect and must be allocated using a logical causal-beneficial relationship.

Direct costs are accumulated according to the following cost elements:

  • Labor
  • Material
  • Travel
  • Other Direct Costs (ODC)
  • Subcontractors

Fringe

Fringe costs are those costs to maintain W-2 employees. Notice the italics. Fringe costs support employees already hired by the business and exclude human resources, job fairs, advertising, background checks, and other costs to attract or onboard new hires. Those costs are part of Overhead, G&A, or a separate human resources pool. Fringe costs are incurred for W-2 employees and specifically exclude temporary employees, independent contractors, and subcontractors.

Fringe costs include:

  • Employer taxes
  • Health insurance
  • Retirement
  • Paid absences
  • Other fringe benefits (e.g., gym memberships)

Overhead

Overhead costs are those costs incurred to support multiple customers, contracts, projects/jobs, products, or services. These costs are not easily or fairly assignable to a single final cost objective.

Overhead costs include:

  • Idle or non-productive labor
  • Supervisory labor
  • Training
  • Supplies
  • Equipment
  • Facilities*

“Idle labor” does not mean that employees are sitting around doing nothing but have no direct work to perform. Overhead/idle labor can include cleaning, preparations for other work, training, or other non-productive tasks.

*Contractors not using a separate facilities pool usually include facilities in overhead since most facilities expenses are incurred to perform or support customer work.

General & Administrative (G&A)

G&A costs are those costs incurred to run the business as a whole. These are costs you would incur with zero, one, or 100 customers.

G&A costs include:

  • Labor
  • Applied Fringe
  • Accounting
  • Business development
  • Human resources
  • Information technology*
  • Registrations, taxes, and licenses**
  • Bids & Proposals (B&P)
  • Internal Research and Development (IRAD)

*Unless captured in a separate pool
**These are registrations, taxes, and licenses for the business as a whole. Similar fees incurred under different circumstances may be charged into overhead or an intermediate pool such as facilities.

G&A costs can include internal labor and the cost of consultants, advisors, or other outsourced services.

Unallowable

According to FAR 31.201-2, unallowable costs are those costs deemed unallowable by the government based on:

  1. Reasonableness
  2. Allocability
  3. Standards promulgated by the CAS Board, if applicable, otherwise, generally accepted accounting principles and practices appropriate to the circumstances
  4. Terms of the contract
  5. Any limitations set forth in this subpart

Please see our resource on FAR 31 and Unallowable Costs for more information.

Intermediate Cost Pools

Intermediate cost pools are used to capture and allocate costs that benefit multiple departments, functions, or other cost pools when the costs incurred cannot be easily or fairly assigned. Like primary cost pools, intermediate cost pools must be allocated using a logical causal-beneficial relationship.

Intermediate cost pools may include:

  • Facilities
  • Information Technology (IT)
  • Human Resources

Facilities

Facilities are the costs to own, rent, or maintain buildings, offices, and warehouses.

Facilities costs may include:

  • Rent
  • Depreciation
  • Maintenance and repairs
  • Utilities
  • Taxes
  • Insurance
  • Labor
  • Applied fringe

Information Technology (IT)

Information technology is the cost of providing the organization with technology, information, and communication resources.

IT costs may include:

  • Computer hardware
  • Computer software
  • Telephones
  • Depreciation
  • Maintenance and repairs
  • Insurance
  • Labor
  • Consultants
  • Cybersecurity certifications and audits
  • Threat monitoring services
  • Applied fringe
  • Applied facilities

Human Resources (HR)

Human resources are the costs to provide human capital management and oversight to the business.

HR costs may include:

  • Job fairs
  • Advertising
  • Background checks
  • General training
  • Onboarding
  • Labor
  • Applied fringe

Acceptable Allocation Methods

Once pools are established and costs are collected, they must be allocated to final cost objectives (e.g. contracts, jobs/projects, products, services) using an acceptable allocation method based on a logical causal-beneficial relationship. This means there must be a logical relationship between the pool and base.

For example, fringe costs allocated over all W-2 labor, because fringe is incurred to maintain W-2 employees.

Direct

Direct costs are assigned to their proper final cost objective (e.g. contract, job/project, product, service) at the time of incurrence.

Fringe

Fringe costs can be allocated using one of four acceptable methods:

  1. Total W-2 labor dollars – this approach allocates fringe over direct and indirect labor dollars (allowable and unallowable). This is the most common method and our recommendation since it is the most fair and generates the least amount of variances.
  2. Total W-2 labor hours – this approach allocates fringe over direct and indirect labor hours (allowable and unallowable). This is the least common and not recommended because of the extra work necessary to estimate total hours worked by employee and the high risk of over- or under-absorption of costs based on actual hours worked (as compared to option #1 which maintains a steady rate regardless of the number of hours worked).
  3. Direct W-2 labor dollars – this approach allocates fringe over only direct labor dollars. This approach is common (even required) in some industries such Architect/Engineer (A/E). While this is an acceptable method, users lose visibility into the full relationship of fringe costs and labor costs since only a portion of labor costs are in the base. This method is also subject to swings in rates due to seasonality of labor or other significant shifts of labor between direct and indirect (e.g. during a downturn in business or lag between contracts).
  4. Direct W-2 labor hours – similar to #2 in that the allocation is over hours instead of dollars, and #3 in that it only involves direct labor.

G&A

G&A costs can be allocated using one of two acceptable methods:

  1. Total Cost Input (TCI) – this is the most common method and allocates G&A costs over most other costs including direct, fringe, and overhead. While this is referred to as total cost input, the base does exclude unallowable G&A costs; unrecovered fringe and overhead (see below); the portion of fringe included in the G&A pool; and the portion of overhead applied to B&P and IRAD costs included in the G&A pool.
  2. Value-Added – this method is less common and usually only used in conjunction with a Material & Subcontract Handling (M&SH). While this method could be selected without an M&SH pool, it’s likely to be questioned by auditors.

Overhead

Overhead costs can be allocated using one of six acceptable methods:

  1. Direct labor dollars – this method allocates overhead costs over direct labor dollars plus applied fringe (see “Math of Indirect Rates” below) and is the most common approach, especially in service or high labor industries.
  2. Direct labor hours – similar fringe option #2 above, overhead costs are allocated over direct labor hours plus applied fringe. Similar to fringe options #2 and #4 above, the need for accurate estimation of total hours worked leads to higher risk of over- or under-absorbing (aka billing and fully recovering) overhead costs.
  3. Direct material costs – this method is useful when material costs significantly outweigh labor costs and may be beneficial to a reseller of products, especially one with a significant amount of drop-ship inventory.
  4. Total prime costs (direct labor  + applied fringe + direct materials) – reflects value added to the materials such as some assembly or manufacturing environments. 
  5. Units of production – this method is useful in a high volume production environment. Multiple rates could be developed to support multiple production or assembly lines.
  6. Machine hours – this method is useful in a highly automated or heavily machined environment.

Unallowable

Unallowable costs are not allocated, but some are in included in the base of overhead and G&A as appropriate. See our Resource on Unallowable Costs for more details.

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