Develop a Logical and Consistent Method for the Allocation of Indirect Costs

As explained in previous videos, your indirect rates are a series of numerators (cost pools) and denominators (bases). When you design your chart of accounts, be sure that your costs are being accumulated by cost pool (overhead, G&A, F&A, fringe, etc.). Any allocations between cost pools need to be defined in your accounting system.
Bases need to also be clearly defined in your accounting system. For example, the G&A cost pool is typically G&A costs, plus any allocated overhead. The G&A base is typically direct costs plus overhead costs. When developing your accounting system, make sure the method by which you apply your indirect costs is logical and consistent.
Typical indirect rate cost pools for Department of Defense (DOD) contractors includes fringe, overhead and G & A (general and administration) for three-tier rate structures and overhead and G & A for two-tier rate structures. Fringe costs are included in the overhead pool and allocated to the G & A pool for two-tier rate structures.
Typical indirect rate cost pools for NIH and NSF contractors includes fringe and F & A (facilities and administration) for two-tier rate structures and F & A for one-tier rate structures. Fringe is included in F & A for the single F & A rate structure.
Your chart of accounts must segregate costs by indirect rate type (fringe, overhead, G & A, F & A, etc.) so the total costs for each indirect pool can be computed before being allocated to intermediate of final cost objectives.
An intermediate cost pool is where indirect costs are accumulated in an account to be allocated to other intermediate or final cost objectives later on. For example, fringe costs (where the contractor DOES NOT have a fringe rate) is accumulated in its own cost pool within the chart of accounts (the aforementioned 6000 series accounts). These costs are then allocated from its intermediate cost pool to the final overhead and G & A cost pools through an allocation depending on a formula that is logical, such as the proportion of G & A labor to total productive labor.
A final cost pool is where indirect costs are accumulated and are not allocated anywhere else in the rate calculation. For example, accounting is always a G & A or F & A cost, therefore, no allocation is necessary and this cost is assigned to its final cost objective accordingly.
Your company incurs $100,000 of fringe costs, $300,000 of overhead costs and $150,000 of G & A costs. Your company has a two-tier indirect rate structure (overhead and G & A) where fringe is allocated to overhead and G & A and overhead (including allocated fringe) is allocated to G & A. As a result of this rate structure (this is a common structure), fringe and overhead are intermediate costs where there is an allocation to another intermediate of final cost objective. G & A is a final cost objective.
Your company has determined that the most logical and consistent method of allocating overhead and G & A is to use the proportion of G & A labor over total productive labor. This results in an allocation ratio of 10%.
Your general ledger includes $550,000 in total indirect costs ($100,000, $300,000 and $150,000 to fringe, overhead and G & A respectively). However, since your company does not have a fringe indirect rate, you need a logical and consistent method to allocate fringe to overhead and G & A. As previously discussed, we used the G & A relationship to total productive labor of 10% as our allocation ratio. Since fringe is being allocated, fringe is an intermediate cost objective.
We allocate $10,000 of fringe costs to the G & A final cost objective ($100,000 * 10% = $10,000) with the remainder being added to the intermediate overhead cost pool. Next, we allocate 10% of overhead costs (excluding fringe since this is already allocated to G & A) which totals $30,000 ($300,000 * 10% = $30,000). Once completed, our remaining overhead costs will become their own final cost objective and total $360,000, which is to be divided by its base to determine the overhead indirect rate. G & A has increased from $150,000 to $190,000 for its final cost objective to be divided by its based to determine the G & A rate.

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