Effective cost segregation is a foundational element of any accounting system subject to Defense Contract Audit Agency (DCAA) review.
For organizations working under cost-type or time-and-material contracts with the Department of Defense, accurate classification of direct and indirect costs is required to meet federal standards and support audit readiness.
Segregating Direct and Indirect Costs Clearly
Cost segregation begins with a clear distinction between direct and indirect costs, a core requirement under DCAA guidelines.
Direct costs are those that can be specifically identified with a single contract or final cost objective, such as labor hours logged on a specific project, materials purchased for a particular deliverable, or subcontractor expenses directly attributable to a single contract.
Indirect costs, by contrast, support multiple contracts or functions and are typically grouped into cost pools such as overhead, fringe benefits, and general and administrative (G&A) expenses.
Establishing a chart of accounts that separates these two categories from the outset allows for reliable financial reporting and facilitates easier review during audits. For example, general ledger accounts should distinctly categorize direct labor and materials separate from accounts used to accumulate facility rent, executive salaries, and IT support, which are more appropriately classified as indirect expenses.
Clear mapping in the accounting system helps prevent cost misclassification and reduces the risk of questioned costs during audit procedures.
Assigning Costs Accurately to Contracts
An accounting system designed to comply with DCAA standards must be capable of identifying costs by individual contract or project. Every contract is considered a final cost objective under DFARS 252.242-7006, and any cost that benefits only that contract must be directly charged to it.
Labor charges, for instance, must reflect actual time worked on specific contracts rather than defaulting to a general pool. If an engineer splits time equally between two projects, labor distribution must reflect that 50/50 allocation based on accurate time entries, not on estimated budgets or convenience.
Project-level cost tracking must be consistently applied across all departments and functions involved in contract execution. The accounting system should also accommodate specific contractual requirements, such as segregation by Contract Line Item Number (CLIN) or tracking pre-production versus production phases.
Failure to accumulate costs at the required levels of detail can lead to negative audit findings and difficulties during incurred cost submissions.
Designing Logical Indirect Cost Pools
Indirect costs must be accumulated in homogeneous pools and allocated to final cost objectives using logical, consistent bases that reflect the actual benefit received by each contract.
FAR 31.203 specifies that cost groupings and allocation methods must have a clear causal relationship to the cost objectives they support. For instance, an engineering overhead pool should be allocated based on direct engineering labor hours rather than total company labor or sales revenue.
Indirect pools should be reviewed periodically to confirm that the contents remain appropriate and that the chosen allocation base continues to accurately reflect operations. Pool composition should be documented and consistently applied.
Changes to pool structure or allocation bases should be made with a clear justification, documented rationale, and proper approvals. Lack of discipline in indirect cost handling is a common source of audit findings and payment withholdings.
Preventing Misclassification of Unallowable Costs
FAR Part 31 provides detailed cost principles that distinguish allowable from unallowable expenses.
Costs such as alcoholic beverages (FAR 31.205-51), lobbying activities (FAR 31.205-22), fines and penalties (FAR 31.205-15), and entertainment (FAR 31.205-14), are specifically unallowable. They must be excluded from any amounts billed to the government. A DCAA-compliant accounting system must be structured to record and isolate unallowable expenses in separate general ledger accounts.
For example, travel accounts should be reviewed to remove unallowable expenses such as business-class upgrades or per diem overages, and marketing costs should be reviewed to confirm they do not include sponsorships or entertainment.
Policies must clearly define unallowable categories and require that employees either flag these costs or obtain clarification before submission. Periodic review of high-risk accounts helps maintain accuracy and reduce audit exposure.
Any portion of an expense deemed unallowable must be fully excluded from all indirect cost pools used in government billing.
Maintaining Cost Segregation Through Timekeeping and Internal Controls
Labor costs typically represent the most significant expense category on cost-type contracts and are often subject to detailed DCAA scrutiny. Daily timekeeping by employees, timesheet certification, and supervisory review form the basis of reliable labor cost accumulation.
Employees must record time based on the actual work performed and charge it to the appropriate job code or indirect account. Corrections to timesheets must be documented with the original entry and the reason for the change, including identification of the person who authorized the correction.
The accounting system should process time data into labor distribution reports that assign costs to contracts or indirect cost pools according to time entries. Aligning labor effort with financial posting is essential for proper cost segregation.
Controls such as segregation of duties, supervisory sign-off on cost adjustments, and periodic internal audits further reinforce proper cost handling and mitigate the risk of inaccurate charges. DCAA expects to see evidence of these controls during audits and system reviews.
Building Confidence Through Accurate Cost Practices
Effective cost segregation is a foundational element of compliance with DCAA requirements and a core component of maintaining eligibility for government contracts.
Through the implementation of precise cost classification, structured indirect cost pools, disciplined labor tracking, and consistent application of FAR and DFARS standards, organizations can reduce audit risk and maintain accurate financial control across all active projects.
At Diener & Associates, the team understands the operational and regulatory pressures to government contracting. For guidance on developing or evaluating a DCAA-compliant accounting system, schedule a consultation online or call 1-(703)-386-7864 to speak with our experienced CPAs.