Indirect Cost Series: Part Two – Cost Pools and Developing an Indirect Cost Rate

In part one of our indirect costs series, we focused on what indirect costs are and why they are important to contractors. In this post, we will discuss cost pools and how to develop an appropriate indirect cost rate to allocate indirect costs to your construction projects.

As discussed previously, indirect costs are costs that directly arise from contracts but are not easily attributable to individual projects. Due to this, a rate must be determined to allocate these indirect costs to particular jobs. Before determining a rate you must determine how to accumulate indirect costs into cost pools.

Understanding Cost Pools

A cost pool accumulates similar indirect costs to be allocated to individual projects based on the indirect cost rates developed. Examples of cost pools include equipment, labor burden, vehicles, etc. In developing and tracking cost pools, a company must ensure that the money attributed to cost pools are truly indirect costs and not direct costs or general and administrative costs.

Indirect costs must then be allocated in a consistent way once an indirect cost rate has been established. Examples of rates include those based on direct labor costs, direct labor hours, or equipment usage hours. These cost drivers should be matched to cost pools that have a strong relationship with the incurrence of these costs. Take the following scenario (expanding on the example in Part One):

• Contractor XYZ has the following projects in 2015:
  • Project A and Project B
• At the end of 2015, Contractor XYZ incurred $250,000 in indirect costs related to depreciation and repairs and maintenance for construction equipment used on both jobs.
• The cost driver matched to the equipment cost pool in this scenario should be equipment usage hours.
• If Project A has 4,000 equipment usage hours and Project B had 6,000 equipment usage hours, then the $250,000 would be allocated as follows:

Alternatively, using the same data, Contractor XYZ could have allocated the indirect costs using an indirect cost rate based on the equipment hours incurred throughout the year, compared to waiting until year-end to allocate the costs. The following example demonstrates this scenario:

• At the beginning of 2015, Contractor XYZ originally estimated that $230,000, of indirect costs would be incurred related to these expenses and the equipment would require about 10,000 usage hours during the year . This would provide an indirect rate and allocation as follows:

This scenario provides a total of $230,000, of indirect costs allocated to the job when a total of $250,000 of costs was incurred. The contractor could decide to reallocate the costs to the projects or if total costs incurred where not material, the contractor could attribute the difference as under-applied. A contractor’s specific circumstances will determine what treatment is best.

Additional examples of matching cost pools to cost drivers include:

• Allocating labor burden based on direct labor hours
• Allocating liability insurance based on total direct costs
• Allocating quality control based on direct labor hours

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