Government Contract Costs: Direct vs Indirect Under FAR 31.2

Every dollar a government contractor charges to a cost-type or time-and-materials contract gets classified as either a direct cost or an indirect cost. The classification matters because it determines how the dollar flows through the accounting system, how it gets billed, and how DCAA will evaluate it during an incurred cost audit. FAR 31.202 defines direct costs as those identified specifically with a particular final cost objective (a contract, a task order, a delivery order). FAR 31.203 defines indirect costs as those incurred for the joint benefit of more than one final cost objective, accumulated in pools, and distributed to contracts through an allocation base. The three-part test from FAR 31.201 governs whether a cost, once classified, is actually chargeable: it must be allowable (not prohibited by any subsection of FAR 31.205), allocable (it benefits the contract being charged), and reasonable (a prudent business person would incur it in similar circumstances). Getting the classification wrong does not just create billing errors. It can trigger audit findings, rate adjustments, questioned costs, and, in extreme cases, False Claims Act exposure.

What is the three-part test for allowability?

Before a cost can be charged to a government contract, whether directly or through an indirect rate, it must pass all three prongs of the FAR 31.201 test. First, the cost must be allowable, meaning no provision of FAR 31.205 specifically prohibits it. Second, the cost must be allocable to the contract being charged, meaning the cost either benefits that contract directly or, in the case of indirect costs, benefits the business operations that support the contract. Third, the cost must be reasonable, meaning a prudent business person in a competitive environment would have incurred a similar cost under similar circumstances.

The three prongs are independent gates. A cost can be reasonable and allocable but still unallowable because FAR 31.205 specifically prohibits it (entertainment expenses, for example, are always unallowable regardless of their business purpose). A cost can be allowable in principle and reasonable in amount but fail the allocability test because it has no connection to the contract being charged. DCAA auditors evaluate each prong separately, and a cost that fails any single prong gets questioned in its entirety.

The practical effect is that a contractor’s accounting system must track enough detail to demonstrate all three prongs for every cost. The labor distribution system must show which employees worked on which contracts and for how many hours (allocability). The purchasing system must connect material costs to specific contracts or to indirect pools (allocability). The approval and review process must show that costs were incurred at market rates and for legitimate business purposes (reasonableness). And the chart of accounts must segregate unallowable costs so they never touch a billing rate or an indirect pool that feeds contract charges (allowability).

What are direct costs under FAR 31.202?

A direct cost is any cost that can be identified specifically with a particular final cost objective. In practice, this means costs where you can look at the transaction and point to the one contract that caused it. The most common direct cost categories are labor, materials, subcontractor costs, travel, and other direct costs (sometimes called ODCs).

Direct labor. The hours an employee works on a specific contract, at the employee’s loaded labor rate (base salary divided by available hours, or the hourly billing rate specified in the contract). The employee’s timesheet is the source document. If an engineer spends 32 hours in a week on Contract A and 8 hours on Contract B, 32 hours of that engineer’s cost go to Contract A and 8 hours go to Contract B. The remaining hours (vacation, holiday, sick, training, unallowable time) go to the appropriate indirect pool.

Direct materials. Materials purchased for use on a specific contract. Circuit boards for a defense electronics contract, server hardware for an IT infrastructure contract, reagents for a research contract. The purchase order and receiving report tie the material to the contract.

Subcontractor costs. The amounts billed by subcontractors performing work on a specific contract. Each subcontract invoice maps to the prime contract it supports. On contracts with significant subcontractor content, subcontractor costs can exceed direct labor as the largest cost element.

Direct travel. Airfare, hotel, per diem, and ground transportation for employees traveling on a specific contract’s business. The travel authorization and expense report identify the contract charged.

Other direct costs (ODCs). Anything else chargeable to a single contract: consultant fees, special testing, printing, shipping, licenses purchased for a specific project. The key is that the cost is identifiable to one contract and is not part of a pool allocated across all contracts.

What are indirect costs under FAR 31.203?

Indirect costs are costs that cannot be attributed to a single contract but are necessary to the overall operation. They are accumulated in pools and distributed to contracts through indirect rates. FAR 31.203 defines them as costs incurred for a common or joint objective that cannot be identified specifically with a particular final cost objective. The pools are organized by function, and each pool has its own allocation base. The most common structure for a government contractor uses three or four pools.

Fringe benefits pool. This pool contains all employer-paid benefits: the employer’s share of FICA (Social Security and Medicare taxes), FUTA and SUTA (federal and state unemployment taxes), health insurance premiums, dental and vision insurance, life and disability insurance, paid time off (the cost of vacation, holiday, and sick hours), 401(k) matching contributions, workers’ compensation insurance, and any other benefit that attaches to the employee rather than to a specific contract. The fringe pool is typically allocated using total direct labor dollars or total labor dollars (direct plus indirect) as the base. The rate is expressed as a percentage: if the fringe pool totals $1.2 million and total labor dollars are $4 million, the fringe rate is 30%.

Overhead pool. The overhead pool captures costs related to the operational support of contract work, beyond fringe benefits. Common items include facility costs (rent, utilities, building maintenance, property taxes), depreciation on equipment used across contracts, supervisory and management labor that supports contract performance but is not charged directly to any contract (a program manager who oversees multiple contracts, for example), indirect labor (employees performing non-billable work such as quality assurance, proposal support on the technical side, or internal process improvement), office supplies, and information technology costs (servers, software licenses, help desk support) when those costs support contract execution. The overhead pool is typically allocated on direct labor dollars or direct labor hours.

General and administrative (G&A) pool. G&A costs are those that benefit the company as a whole, not just the contract-performing functions. Executive compensation, corporate-level accounting and finance, human resources, legal, corporate insurance (general liability, D&O, E&O), information technology costs that serve the whole organization, independent research and development (IR&D), and bid and proposal (B&P) costs. The G&A pool is the broadest pool and is allocated last in the rate structure. The allocation base is typically total cost input (all direct costs plus all other indirect costs applied before G&A) or, less commonly, value-added cost input (total cost input minus material and subcontractor costs, which avoids distortion when a single contract has a large material or subcontract pass-through).

Separate pools (optional). Some contractors maintain a material handling pool (costs of purchasing, receiving, inspecting, and storing materials) or a subcontract administration pool (costs of managing subcontractors), allocated to contracts based on direct material dollars or direct subcontractor dollars respectively. These pools make sense when the costs are significant enough that including them in overhead or G&A would distort the rates applied to contracts with little or no material or subcontract content.

Why does the consistency requirement matter?

FAR 31.202 and 31.203 require that costs be classified consistently. Once a contractor treats a type of cost as direct, the same type of cost must be treated as direct on all contracts. Once a type of cost is treated as indirect, it must be indirect everywhere. This is not a recommendation. It is an enforceable requirement, and DCAA auditors specifically test for it.

The rule exists to prevent cost manipulation. Without it, a contractor could charge travel as a direct cost on cost-reimbursable contracts (where the government pays the actual cost) and then bury the same type of travel in an indirect pool on fixed-price contracts (where higher indirect rates do not directly increase the contract price). The effect would be double-charging the government: once through the direct charge on the cost-type contract and again through the inflated indirect rate that the cost-type contract also absorbs.

Consistency applies at the cost-type level, not the transaction level. If travel is a direct cost, then all travel that benefits a specific contract must be charged directly to that contract. You cannot charge some travel directly and dump the rest into overhead because the contract is running over budget or because the travel authorization was not completed before the trip. The accounting system must have controls that enforce the classification at the point of entry, not at the point of billing.

Which costs are unallowable under FAR 31.205?

FAR 31.205 contains dozens of subsections, each addressing a specific cost type. Some costs are always unallowable. Others are allowable with conditions. A contractor’s accounting system must segregate unallowable costs so they are excluded from both direct charges and indirect rate computations. The major categories of unallowable costs include:

• Entertainment (FAR 31.205-14). Always unallowable. Tickets to sporting events, concerts, theater, golf outings, and similar activities, even when the stated purpose is client entertainment or employee morale.
• Alcoholic beverages (FAR 31.205-51). Always unallowable. No exceptions, regardless of the business purpose.
• Donations and contributions (FAR 31.205-8). Unallowable, with limited exceptions for certain community service activities.
• Lobbying costs (FAR 31.205-22). Costs of influencing legislation, executive orders, or government policy are unallowable.
• Fines and penalties (FAR 31.205-15). Always unallowable. OSHA fines, tax penalties, SEC penalties, and any other fine or penalty imposed for a violation of law or regulation.
• Bad debts (FAR 31.205-3). Unallowable. The government is not responsible for a contractor’s inability to collect from other customers.
• Contingencies (FAR 31.205-7). Provisions for future events that may or may not occur are unallowable. Actual losses, once they materialize, may be allowable.
• Interest expense (FAR 31.205-20). Generally unallowable, with narrow exceptions under the facilities capital cost of money rules (CAS 414) and certain imputed costs.
• Advertising (FAR 31.205-1). Institutional or promotional advertising is unallowable. Advertising for recruitment of personnel is allowable.
• Compensation above certain benchmarks (FAR 31.205-6). Executive compensation above the annual cap (set by OFPP and published annually, currently benchmarked against the compensation of senior executives in comparable organizations) is unallowable. This cap applies per-person and is tested against the total compensation package.

The practical requirement is an “unallowable” designation in the chart of accounts. When someone books an entertainment expense, the account must be flagged so that the cost is automatically excluded from the indirect rate computation and never appears on a billing. Many contractors create a separate G&A-Unallowable account or use subaccounts within each pool to segregate allowable from unallowable costs.

How do indirect rates get computed?

The indirect rate for each pool is the total dollars in the pool divided by the allocation base. The contractor proposes provisional (estimated) rates at the start of the fiscal year, bills contracts using those provisional rates during the year, and then computes actual rates after year-end based on actual costs. The actual rates are submitted to DCAA through the incurred cost submission (ICS), which is due six months after the contractor’s fiscal year-end. DCAA audits the ICS, and the contracting officer establishes final rates that determine the actual amount owed.

The allocation base for each pool must represent a causal or beneficial relationship between the pool and the contracts absorbing the cost. The common bases and their uses:

Total direct labor dollars. The most common base for fringe and overhead pools. It works well when labor is the primary cost driver and the labor mix (skill levels and billing rates) is relatively uniform across contracts. If one contract uses only senior engineers at $80/hour and another uses only junior analysts at $35/hour, a direct labor dollar base means the senior engineer contract absorbs a disproportionately large share of overhead, which may or may not reflect economic reality.

Total direct labor hours. An alternative to labor dollars that avoids the distortion from different pay rates. Each hour of direct labor absorbs the same dollar amount of overhead regardless of the employee’s wage. This base works well when the overhead resources (office space, equipment, supervision) are consumed roughly equally per labor hour regardless of the employee’s seniority.

Total cost input (TCI). Used primarily for the G&A pool. TCI includes all direct costs (labor, materials, subcontractors, travel, ODCs) plus all applied indirect costs (fringe and overhead). This base distributes G&A proportionally across all contract activity. The limitation: contracts with large material or subcontract pass-throughs absorb a disproportionate share of G&A, even though the G&A activities (executive management, accounting, HR) do not scale linearly with material purchases.

Value-added cost input. A variant of TCI that excludes material and subcontractor costs from the base, or includes only a portion of them. This avoids the distortion problem with TCI but requires justification and consistency. If a contractor has one contract with $5 million in direct labor and another with $500,000 in direct labor but $10 million in subcontractor pass-through, value-added cost input prevents the second contract from absorbing a wildly disproportionate share of G&A.

What are B&P and IR&D costs?

Bid and proposal (B&P) costs are the costs a contractor incurs in preparing, submitting, and supporting proposals for new contracts. These include the labor of engineers and managers writing the technical proposal, the cost of printing and binding, consultants brought in for proposal strategy, and the time spent on oral presentations. Independent research and development (IR&D) costs are the costs of research and development work that is not sponsored by a government contract but that has potential relevance to the contractor’s government business.

FAR 31.205-18 governs B&P and IR&D. Both cost types are allowable (with conditions) and are typically included in the G&A pool, where they are allocated to all final cost objectives. Some contractors maintain a separate B&P/IR&D pool if the costs are significant enough to warrant separate tracking and allocation. The rationale for G&A allocation is that B&P and IR&D benefit the entire organization by generating future contract wins and advancing the contractor’s technical capabilities.

The key conditions for allowability are that the costs must be reasonable in amount (a contractor spending 15% of revenue on B&P when the industry norm is 3-5% will face scrutiny) and must be properly identified and accumulated. B&P projects should have their own project numbers in the accounting system, with labor charged via timesheet the same way contract labor is tracked. IR&D projects similarly need project numbers, budgets, and time tracking. Sloppy tracking of B&P and IR&D is a common DCAA finding, because the costs are significant, the documentation requirements are the same as for direct contract costs, and some contractors treat them as an afterthought.

The distinction between B&P and marketing is important. B&P costs are the costs of preparing a specific proposal in response to a specific solicitation (or an unsolicited proposal for a specific opportunity). Marketing costs (attending trade shows, sponsoring conferences, general relationship-building with potential customers) are separate and may be allowable under FAR 31.205-1 (advertising) and FAR 31.205-38 (selling costs), but they are not B&P. Miscoding marketing costs as B&P, or vice versa, creates audit risk.

How does this feed the incurred cost submission?

The incurred cost submission (ICS) is the annual filing that presents the contractor’s actual costs for the fiscal year, organized by direct costs per contract and indirect costs by pool, with the indirect rate computations. The ICS is required by FAR 52.216-7 for any contractor with cost-reimbursable, time-and-materials, or labor-hour contracts. It is due six months after the contractor’s fiscal year-end.

The ICS is essentially a reconciliation: total costs per the books, broken into direct costs by contract, indirect costs by pool, and unallowable costs removed. The schedules show each indirect pool, the costs in the pool (with unallowable costs identified and excluded), the allocation base, and the resulting rate. DCAA uses the ICS as the starting point for the incurred cost audit, where auditors verify that costs are properly classified, allowable, allocable, and reasonable.

The direct-versus-indirect classification drives the entire structure of the ICS. If a cost is classified as direct, it appears on the schedule for the contract it was charged to, and the auditor tests whether it meets the allocability and reasonableness standards for that specific contract. If a cost is classified as indirect, it appears in a pool, and the auditor tests both the composition of the pool (are all costs properly included? are unallowable costs excluded?) and the allocation base (does it represent a causal or beneficial relationship?).

Contractors that do not file the ICS on time, or that file an incomplete ICS, face consequences. DCAA may issue a penalty letter. The contracting officer may withhold payment (up to the full amount of indirect costs billed) until the ICS is submitted and audited. Final indirect rates cannot be established without the ICS, which means the contractor’s invoiced amounts remain provisional indefinitely, creating financial uncertainty for both the contractor and the government.

How should the chart of accounts be structured?

The chart of accounts is the backbone of the cost classification system. For a government contractor, it must accomplish four things simultaneously: separate direct costs from indirect costs, separate indirect costs into the correct pools, identify and segregate unallowable costs, and provide enough detail for DCAA to verify each cost element during an audit.

A typical structure for a small to mid-size government contractor organizes revenue accounts (4000 series), direct cost accounts (5000 series), indirect cost pool accounts (6000-7000 series, with a separate range for each pool), and unallowable cost accounts (8000 series or subaccounts within each pool). Within the direct cost accounts, the contractor creates accounts for each major cost type: direct labor (often subdivided by labor category), direct materials, subcontractor costs, direct travel, and other direct costs. Within each indirect pool, the accounts mirror the cost types: fringe benefit accounts (FICA, FUTA, SUTA, health insurance, PTO, 401k match), overhead accounts (rent, utilities, depreciation, indirect labor by category, supplies, IT), and G&A accounts (executive compensation, accounting, legal, HR, insurance, B&P, IR&D).

Unallowable costs can be handled in two ways. Some contractors create entirely separate unallowable accounts (Entertainment, Alcohol, Donations, Lobbying, Penalties). Others create paired accounts within each pool: G&A-Meals (allowable) and G&A-Meals (unallowable, the portion exceeding per diem or the entertainment component). Either approach works as long as the system reliably prevents unallowable costs from entering the indirect rate computation. The paired-account method is often easier because it keeps the cost near its functional category, which simplifies budgeting and management reporting.

The chart of accounts must also support job costing (tracking direct costs to individual contracts) and timekeeping integration (the labor distribution system must map timesheet entries to the correct direct or indirect account). In QuickBooks, this means using the customer/sub-customer or class structure to tag each transaction to a contract. In Deltek Costpoint, Unanet, or JAMIS (systems built for government contractors), the project/task/organization structure handles this natively. Regardless of the software, the principle is the same: every transaction must be coded to a contract (if direct) or a pool (if indirect) at the time of entry, not at the end of the month when someone reconciles.

What allocation base should I use?

Choosing the right allocation base for each indirect pool is a judgment call, but FAR 31.203 provides the guiding principle: the base must represent a causal or beneficial relationship between the indirect costs in the pool and the final cost objectives absorbing them. In practice, this means the base should approximate the driver of the costs being allocated.

For the fringe pool, the natural base is total labor dollars (or total labor hours). Fringe benefits attach to employees, and the cost of those benefits scales with the number of employees and their compensation. Every hour of labor, whether direct or indirect, generates fringe costs (payroll taxes, insurance contributions, PTO accrual). An allocation on total labor dollars distributes fringe costs proportionally to the labor that generates them.

For the overhead pool, total direct labor dollars or total direct labor hours are the most common bases. Overhead costs (facility, equipment, supervision) support the work performed on contracts, and direct labor is the best proxy for how much support each contract consumes. A contract that uses 1,000 direct labor hours consumes roughly twice as much office space, IT support, and supervisory attention as a contract that uses 500 hours.

For the G&A pool, total cost input is the standard base. G&A costs (executive management, accounting, legal) benefit the entire organization proportionally to the total activity on each contract. Value-added cost input is an alternative when significant material or subcontract pass-throughs would distort the G&A allocation. A contractor that runs a $10 million program with $8 million in subcontractor pass-through and $2 million in direct labor should seriously consider a value-added base for G&A, because the executive suite, HR, and accounting departments are not working ten times harder on that contract compared to a $1 million pure-labor contract.

Whichever base is chosen, it must be documented in the contractor’s disclosure statement (if CAS-covered) or in the written accounting policies (if CAS-exempt but subject to FAR 31.2), and it must be applied consistently from year to year. Changing the allocation base requires justification and, for CAS-covered contractors, a change in disclosed practices with notification to the cognizant federal agency official (CFAO).

What should I do next?

The direct-versus-indirect cost classification is the foundation of the entire government contract accounting system. If you are setting up a new system, start with the chart of accounts and the indirect cost pool structure before you begin billing. If you have an existing system, test the consistency requirement by pulling a sample of costs and confirming that the same type of cost is treated the same way on every contract. If you have never filed an incurred cost submission, you are already behind, and the ICS should be your immediate priority.

• DCAA compliant accounting system, the full system requirements that track the costs classified in this guide
• Construction job costing, the parallel cost-tracking system for construction (direct labor, materials, subcontractors, and overhead allocated to projects)
• Restaurant bookkeeping, another industry with rigorous cost classification (food cost, labor cost, prime cost as the control metrics)
• Nonprofit grant management, restricted fund cost allocation under 2 CFR 200, which mirrors many FAR 31.2 concepts (allowability, allocability, consistency)
• Law firm partner compensation, compensation structures for professional services firms where partner compensation is the largest cost element
• Cost Accounting Standards (CAS), the 19 standards that govern how the direct and indirect cost classifications described in this guide are measured, assigned, and allocated consistently across contracts
• Small business government contracting, how set-aside programs work and the cost classification requirements that apply when a small business wins a cost-reimbursement contract

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.