Direct vs. Indirect Costs — Drawing the Line and Holding It

At a Glance

Who it applies to

Every contractor with cost-based pricing or billing — and every contractor that wants a defensible indirect rate

What it obligates

A consistent, documented classification policy applied the same way across all contracts and all customers

Governing authority

FAR 31.202 (direct costs), FAR 31.203 (indirect costs), definitions at FAR 2.101

The consistency rule

FAR 31.202(a) — no final cost objective may bear as a direct cost any cost that, for the same purpose in like circumstances, is treated as indirect

The stakes

Inconsistent classification is a systemic finding: it calls every rate and every voucher into question, not just one cost

What It Is

A direct cost is any cost that can be identified specifically with a particular final cost objective — a contract, a task order, a job. Direct labor and the materials consumed on a specific job are the obvious examples. An indirect cost is one that is not directly identified with a single final cost objective but is identified with two or more, or with at least one intermediate cost objective; it is accumulated into logical cost groupings called pools and then distributed to contracts through an allocation base. Rent, the accountant's salary, general liability insurance, and the office phone system are indirect. FAR 31.202 governs direct costs and FAR 31.203 governs indirect ones, and together they impose a rule far more consequential than the definitions: consistency. FAR 31.202(a) says no final cost objective shall have allocated to it as a direct cost any cost if other costs incurred for the same purpose in like circumstances have been included in any indirect cost pool to be allocated to that or any other final cost objective. In other words, you may treat a category of cost either way — but you must pick one and apply it uniformly. The mirror rule appears in FAR 31.203(b): a cost may not be allocated to a contract as an indirect cost if any other cost incurred for the same purpose in like circumstances has been assigned to that contract as a direct cost. FAR 31.203 also governs how you build the structure: indirect costs must be accumulated in logical groupings determined by their similarity to the activity or benefit involved, and each pool is allocated over a base that permits distribution on the basis of the benefits accruing to the several cost objectives. FAR 31.202(b) adds a practical safety valve for small firms: costs identified specifically with the contract are direct and are charged directly, but minor direct costs may be treated as indirect if the accounting treatment is consistently applied and produces substantially the same results — which is how a firm avoids building a job-cost apparatus around $12 of shipping.

When It Applies

• When you design your chart of accounts and decide which cost categories are direct and which feed which pool.
• When a customer asks you to direct-charge a cost you ordinarily carry in overhead — and the consistency rule says you can't just say yes.
• When you compute indirect rates: the classification decision determines both the pool and the base.
• When a preaward accounting system survey on the SF 1408 tests whether you can segregate direct from indirect costs.
• When you price a proposal, because the same cost classified differently produces a materially different bottom-line price.

Key Features

The SDVOSB Angle

This is the decision that most shapes how competitive an SDVOSB looks on price, and small firms often make it by accident. Consider a program manager who splits time across three contracts and internal work. Direct-charging that labor to each contract by timesheet lowers your overhead pool and therefore your rates, which makes you look leaner on a price evaluation — but it also means the PM's time on internal work has nowhere to go but an indirect account, and it requires real timekeeping discipline. Carrying that PM entirely in overhead is simpler but raises every rate you quote. Neither is wrong; what is wrong is doing it one way on your cost-type contract and the other way on your commercial work, because FAR 31.202(a) makes that inconsistency a finding that infects every rate you have. Two additional SDVOSB-specific notes. First, the direct/indirect line interacts with the limitations on subcontracting under 13 CFR § 125.6: that rule is measured on the amount paid for the contract that goes to subcontractors, so how you classify your own labor doesn't change compliance — but a firm that pushes labor into overhead and buys the actual work from subs can find itself failing the self-performance test while its books look tidy. Second, an SF 1408 preaward survey asks directly whether your system provides proper segregation of direct costs from indirect costs; a firm with no written classification policy fails that question regardless of how good its bookkeeping otherwise is.

How to Comply

1. Write a one-page cost classification policy naming each significant cost category as direct or indirect, and the pool it feeds.
2. Apply the policy identically to federal, commercial, and internal work — the consistency rule is not limited to government contracts.
3. Set up your general ledger and job-cost structure so direct costs are accumulated by contract and indirect costs by pool.
4. Document the benefit rationale for each pool's allocation base so you can defend the base under audit.
5. Use FAR 31.202(b) deliberately for genuinely minor direct costs, and record that the treatment is consistently applied.
6. Revisit the policy when your business changes shape — adding a second location or a commercial line often justifies a new pool, which you should adopt prospectively and document.

Watch Out For

• Direct-charging a cost on one contract because the customer will pay for it while carrying the same kind of cost in overhead elsewhere.
• Changing classification mid-year to improve a rate — cost accounting practice changes need to be deliberate, documented, and applied prospectively.
• Choosing an allocation base because it produces a favorable rate rather than because it reflects benefit.
• Letting uncompensated overtime distort a labor base; hours worked but not paid still consume the base if you use a total-time accounting method.
• Assuming the direct/indirect choice is purely internal — it drives your rates, your price, and how you look against competitors.
• Failing the SF 1408 segregation question because the policy exists only in the bookkeeper's head.

Run the Numbers

Frequently Asked

Primary Sources

• FAR 31.202 — Direct costs
• FAR 31.203 — Indirect costs
• FAR 2.101 — Definitions (direct cost, indirect cost, final cost objective)
• FAR 31.201-4 — Determining allocability

Plain-English reference, not legal, accounting, or tax advice. Cost allowability and accounting determinations are fact-specific, and the FAR, the Cost Accounting Standards, and the statutory dollar thresholds quoted here are amended and escalated for inflation over time. Always read the current FAR text and the cost and payment clauses in your specific contract, confirm the applicable thresholds and your accounting treatment with the contracting officer or cognizant administrative contracting officer, and consult a qualified government-contract accountant or counsel before relying on a cost position, signing a certificate, or submitting a claim.

Related Cost Rules

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