In government contracting, separating direct from indirect costs forms a foundational element of compliance and financial integrity.
Federal Acquisition Regulation (FAR) and Defense Federal Acquisition Regulation Supplement (DFARS) requirements clearly specify how costs must be categorized, recorded, and billed. Accurate segregation supports transparent pricing, withstands audit scrutiny, and maintains eligibility for contract payments.
Adhering to these standards demands disciplined accounting structures, consistent cost treatment, and documented procedures that can withstand both pre-award and post-award evaluations.
For organizations operating in a regulated contracting environment, the ability to clearly distinguish between direct and indirect expenses is a central factor in sustaining operational credibility and maintaining steady cash flow.
Regulatory Framework Governing Direct and Indirect Costs
Federal rules provide clear definitions and boundaries for direct and indirect costs, establishing the groundwork for compliant accounting practices in government contracting.
FAR 31.202 specifies that direct costs must be charged to the benefiting final cost objective. FAR 31.203 outlines the requirements for grouping and allocating indirect costs in a logical and consistent manner.
The rules also prohibit fragmenting allocation bases once accepted, reinforcing the need for consistent application over time. These principles directly influence rate integrity, billing accuracy, and the credibility of incurred cost submissions.
In more stringent terms, DFARS 252.242-7006 identifies proper segregation of direct and indirect costs as a core criterion for an acceptable accounting system. It is paired with requirements for identifying direct costs by contract, maintaining general ledger control, implementing accurate timekeeping, distributing labor correctly, and excluding unallowable costs from amounts billed to the government.
Failure to meet these standards can lead to system disapproval and payment withholds under the Contractor Business Systems clause, with possible financial impacts of up to 5% per deficient system and up to 10% in total across systems.
Impact of Segregation on Compliance and Billing
Segregation of direct and indirect costs forms the foundation for accurate billing under FAR 52.216-7, which governs allowable cost and payment procedures.
Interim billings and final indirect rate settlements depend on incurred cost proposals that reconcile to the books and rate structures. Without clear separation, the accuracy of these submissions is undermined, which can create risks in audits and rate negotiations.
Cost Accounting Standards provide additional guidance:
CAS 418 requires consistent determination of direct and indirect costs, homogeneous cost pools, and allocation measures that reflect a causal-beneficial relationship.- CAS 402 emphasizes the need for consistency in treatment for costs incurred for the same purpose.
- CAS 405 requires identifying and accounting for unallowable costs appropriately, including their treatment in allocation bases when necessary.
Meeting these requirements strengthens the reliability of rate calculations and supports favorable audit outcomes.
How Auditors Evaluate Segregation Practices
Before awarding cost-type work, government agencies conduct pre-award surveys using SF 1408 and the DCAA’s accounting system adequacy checklist.
These tools assess whether an accounting system can segregate direct and indirect costs, accumulate charges by contract, maintain timekeeping and labor distribution accuracy, and operate under general ledger control.
Outsourced accounting providers serving contractors must be prepared to present sample job-cost reports, payroll reconciliations, and general ledger tie-outs during these reviews.
After contract award, the DCAA and DCMA conduct audits under DFARS 252.242-7006 to verify compliance with all 18 criteria, including proper segregation and identification of costs. These reviews test the timeliness and accuracy of postings, the exclusion of unallowables, and the reconcilability of accounts.
Labor-floorcheck procedures further test whether timekeeping and labor distribution practices maintain the separation between direct and indirect labor, with discrepancies often triggering broader accounting system concerns.
Practical Structure for Effective Segregation
A compliant chart of accounts and job-cost structure is the starting point for effective segregation.
Direct costs should be tracked at the project level, while indirect costs should be assigned to intermediate cost objectives that reflect logical groupings under FAR 31.203 and CAS 418. Written policies should guide the classification of direct and indirect costs, including the treatment of minor direct costs charged to indirect accounts under FAR 31.202(b).
Indirect cost pools and their bases should be designed to avoid fragmentation, and any base must include the required content, even for certain unallowables, in accordance with FAR 31.203(d) and CAS 405.
Unallowable costs should be flagged in direct and indirect accounts, with screening occurring at entry and during closing processes. For labor, hours should be recorded daily by cost objective, reconciled to payroll, and integrated into the job-cost ledger and general ledger.
Monthly closes and reconciliations serve as the bridge between recorded costs and billed amounts, helping to maintain accuracy in interim billings. Proper segregation also supports the preparation of incurred cost submissions that meet the adequacy checklist criteria, with pool and base detail that ties directly to the accounting records.
Building a Strong Foundation for Contract Success
Proper segregation of direct and indirect costs strengthens compliance, supports accurate billing, and reinforces credibility during audits, all essential for sustained performance in government contracting.
At Diener & Associates, our team applies decades of experience, responsive service, and deep regulatory knowledge to help organizations maintain systems that meet FAR, DFARS, and CAS requirements.
To discuss how these practices can be implemented effectively, schedule a consultation online or contact us at 1-(703)-386-7864 to work with our professional team of CPAs dedicated to delivering lasting results for clients.