Monday, June 7, 2010

"Cost of Sales" vs "Total Cost Input"

Indirect costs are those that cannot be specifically identified to a contract or a specific cost objective. FAR requires that indirect costs be allocated on a basis of the benefits accruing to those contracts or specific cost objectives (FAR 31.203). Its up to contractors to decide what base is the best for their particular circumstances. It just needs to represent the total activity of a business unit. Some contractors have a single indirect rate while others have multiple rates. As a general rule, larger contractors need more indirect rates than small contractors in order to best allocate indirect costs. The most common allocation bases are direct labor dollars and total cost input (TCI). Overhead rates are commonly allocated over direct labor dollars while General and Administrative costs are commonly allocated over a TCI base. Contractors with a single rate structure generally use one or the other, depending upon their unique set of circumstances. Contractors subject to Cost Accounting Standards (CAS) must consider the requirements CAS 410 when deciding upon their allocation base for General and Administrative Costs. CAS 410 limits the G&A allocation base to one of three; (i) TCI, (ii) Value-added (which is TCI less materials and subcontracts), or (iii) single element. This is not a hard and fast requirement however. If none of these bases are any good, CAS 410 allows contractors to propose and support something different.

Contractors choosing a TCI base for allocating G&A costs, often assume that Cost of Sales (or Cost of Goods Sold) and Total Cost Input (TCI) are the same. The two figures can be the same, though not necessarily so. And Cost of Sales is not an acceptable base for allocating G&A costs. TCI means the costs (excluding G&A) that are allocable to the production of goods and services during a cost accounting period. It includes all costs incurred during the year. Cost of Sales on the other hand are those costs attributable to sales that are recognized during the year. It is adjusted for inventory, work-in-process, and finished goods that have not been sold. Contractors in manufacturing sectors are the most at risk for having significant differences between TCI and Cost of Sales. Contractors in services sectors, less so. Regardless, it is essential that contractors understand what comprises its Cost of Sales before simply using it as a TCI base.

As a reminder, regardless of which allocation base is used (i.e. TCI, value-added, or single element), any unallowable base costs must remain in the base for calculating indirect rates.

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