Burning the Candle at Both Ends – Indirect Cost Allocation and Cost Pools

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We recently spoke to Craig Phillips, Cincom Systems Product Manager for Cincom Manufacturing Business Systems, about what is required for companies to successfully address both commercial and government-contract markets.

Phillips talked about the difficulties posed by indirect cost allocation in the world of project-based manufacturing.

Indirect Cost Allocation plays a large role in project accounting because it deals with those costs that are more difficult to measure and quantify. Most products are made of parts or contain specific ingredients or supplies. These can be documented from a costing standpoint with invoices or other records that help to establish a per-unit cost.

Other costs, including things such as supervisor salaries, cost of utilities or depreciation of machines used in the manufacturing process are less easily captured and documented. These expenses, which are associated with overhead, have to be calculated and applied to the overall cost of a given product using specific percentages or mathematical formulae.

These costs will extend beyond individual products or projects. However, they do affect the individual project as a cost, and they need to be allocated in an acceptable manner.

As might be imagined, there are multiple ways of accomplishing this type of cost allocation. Government contractors need to be aware of and understand that government finance and accounting requirements related to cost are very specific. Government contracts will incorporate these requirements into their terms and conditions either directly or by reference to acquisition regulations published by various agencies and/or financial accounting entities. Two of these regulatory publications, the Federal Acquisition Regulations (FAR) and Cost Accounting Standards (CAS), are very common and widely used.

The capabilities built into the Advanced Project Management components within the Cincom Manufacturing Business Suite ensure that costs documented within a given project are fully compliant with these government requirements.

Cost Pools

Cost pools provide a place to document specific costs that aren’t directly tied to a specific project or product. As an example, the annual utility expenses (lights, heat and water) for the manufacturer are applied to one pool while employee benefits and supervisory salaries might be applied to another. They are recorded in the General Ledger but also in an indirect pool. These pools are intermediate in nature and serve as a place to gather similar expenses for eventual allocation.

For a given reporting period, in most cases monthly, the expenses in each pool are allocated based on a formula that isolates the portion of the total expense that is applicable to the project.

At the General Ledger Level

Let’s look at what happens at the departmental level using a couple of budget expense lines.

For the manufacturing operation, the annual overhead budget is $1,800,000, and the labor budget is $1,200,000. On a monthly basis, these numbers are $150,000 and $100,000 respectively.

If you want to look deeper into specific types of overhead, the budget will show that 15 percent of the overhead budget number covers IT. This is based on a formula that is set up in the budgeting process. So on a monthly basis, manufacturing is spending 15 percent of the $150,000 (or $22,500) on IT. Other types of overhead can be identified and calculated using different percentages.

At the Project Level

At the project level, direct expenses can be applied as they occur. But for indirect expenses, it is a bit more complicated. At the departmental level, we know that the budget for overhead is 150 percent of the budget for labor. This is based on the two budget numbers cited above. So based on that known relationship, a formula for calculating overhead for the project can be based on the direct labor cost multiplied by 1.5. So, for every $50.00 in direct labor, the project would post a $75.00 charge for overhead.

Finally, throughout the year, the company will need to review and adjust the rates used for these calculations. This “true up” process makes sure that changes affecting the accuracy of these processes is maintained.

So, while these dollars are associated with specific projects, they are temporarily accounted for in the intermediate pool associated with manufacturing expenses. Then they move into a final allocation pool associated with a specific project.

Pools make it possible to handle these costs in a consistent, accurate and transparent manner. This is critical to the company because it ensures that costs are covered in pricing, billing and accounting functions. It is also important from the standpoint of auditing. Consistency, accuracy and transparency help promote confidence in the accounting practices used by the company in the eyes of the auditor.

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