How to Set Up an Indirect Cost Pool Structure in QuickBooks®
By Robert Smith, CPA
CEO of ICAT Systems
February 24, 2022
Government contractors often ask me, "How do I organize my cost pools in the QuickBooks chart of accounts?"
Whether you are just starting out in business or you’re a government contractor preparing to bid on an RFP that requires an adequate accounting system, thoughtfully structuring your chart of accounts for government contracting lays the foundation for a DCAA compliant accounting system.
While direct costs are specifically incurred for a contract, indirect costs require further consideration. This is especially important when preparing your accounting system for cost-reimbursement (cost-type) contracts.
How do you account for indirect costs?
There are two ways a government contractor can establish indirect cost pools to record indirect costs in QuickBooks:
- Use the class feature of QuickBooks to assign indirect costs into specified cost pools
- Organize indirect costs into account groups within the QuickBooks chart of accounts
In this article I will explain the options available to government contractors using QuickBooks, and why the chart of accounts approach is the preferred method for tracking indirect costs.
First, let’s review what is required as part of a DCAA compliant accounting system.
What is Required for Indirect Cost Allocation?
SF1408 is the checklist of criteria for the Pre-award Survey of Prospective Contractor Accounting System. This DCAA audit evaluates whether your accounting system is designed to accumulate costs under a Government contract before the contract can be awarded.
A key accounting system criterion included on SF1408 is line item 2(c), which requires that the government contractor’s accounting system provide for:
"a logical and consistent method for allocation of indirect costs to intermediate and final cost objectives."
SF1408 requirement 2(c) entails organizing indirect cost pools in the contractor’s accounting system and allocating the cost pool totals to intermediate and final cost objectives as prescribed in the contractor’s indirect cost allocation policy.
What is an indirect cost pool?
In government contract cost accounting, you must account for both direct and indirect costs.
Direct costs incurred in specific performance of a contract are assigned directly to the contract in the contractor's accounting system.
Indirect costs are incurred to support a business segment or the administrative functions of the business. These costs are accumulated into cost pools. Indirect cost pools are then allocated among those contracts benefitting from the indirect costs.
To track these indirect costs, FAR (Federal Acquisition Regulation) 31.203(c) states:
"The contractor shall accumulate indirect costs by logical cost groupings with due consideration of the reasons for incurring such costs. The contractor shall determine each grouping so as to permit use of an allocation base that is common to all cost objectives to which the grouping is to be allocated. The base selected shall allocate the grouping on the basis of the benefits accruing to intermediate and final cost objectives."
You must group indirect costs into cost pools according to the reason those costs were incurred. Indirect cost pools are then allocated to intermediate and final cost objectives based on the relative benefits accrued by those intermediate and final cost objectives. A contract is a final cost objective.
How do You Record Indirect Costs in QuickBooks?
Government contractors must establish a policy that identifies which indirect cost pools are to be maintained within the accounting system and defines the allocation base elements for each indirect cost pool.
To implement its indirect cost allocation policy, a government contractor using QuickBooks must establish the indirect cost pools specified in its policy within the QuickBooks accounting system.
It’s worth noting for those new to government contract accounting that QuickBooks does not have the ability to allocate indirect costs to government contracts in a manner consistent with the FAR requirements. You will have to go outside of QuickBooks to accomplish this – either manually using spreadsheets or automatically using ICAT with your QuickBooks general ledger. Regardless of your approach to the allocation process, the following steps will help you record the costs to be allocated.
Option 1: Using the Class Method
The first method for establishing indirect cost pools in QuickBooks uses classes to assign indirect costs into specified cost pools. For this approach, each indirect cost pool is set up as a Class in the QuickBooks class list.
When you record an indirect cost transaction, you must:
- Assign the cost to a general ledger account using the "Account" field of the transaction screen and
- Assign the cost to an indirect cost pool using the "Class" field of the transaction screen
Manage Risk of Omitting Expenses from Indirect Cost Pools
While not technically wrong, this approach has risk of omission. It is entirely possible to assign a cost to an account in QuickBooks and fail to assign it to a class, and thereby, fail to include the cost in the cost pool.
To ensure that all indirect costs have been assigned to a cost pool using this approach, you must conduct a review of the cost pool details against the costs accumulated in the general ledger to verify that all costs have been captured. This is a cumbersome manual process that is prone to error.
Option 2 (Preferred): Recording Indirect Costs using the Chart of Accounts
A preferred approach is to organize the indirect costs into account groups in your chart of accounts. Each cost pool is represented by an account grouping in the chart of accounts. Every indirect expense transaction is assigned to a general ledger account within an indirect cost pool.
Advantages of Organizing Cost Pools within the Chart of Accounts
This method ensures that costs are assigned to a cost pool when the transaction is recorded. While it does not eliminate the possibility that a cost is misclassified, it does make sure all costs are included in a cost pool.
Organizing the cost pool structure in the chart of accounts has the added benefit of accommodating an add-on application such as ICAT (Indirect Cost Allocation Tool). ICAT reads costs recorded in the QuickBooks general ledger chart of accounts, automatically calculates indirect rates, and allocates indirect costs to intermediate and final cost objectives as required under the SF1408 item 2(c). You can watch a video on how to set up a QuickBooks chart of accounts for ICAT here.
Establishing Your Indirect Cost Allocation Policy
Regardless of which approach to organizing the indirect cost pool structure in QuickBooks you select, the first step is to identify which cost pools are to be established and enshrine the company’s indirect cost pool structure in a policy statement.
The government contractor’s indirect cost allocation policy should:
- Identify each indirect cost pool
- Describe the types and purposes of costs to be accumulated within each indirect cost pool
- Describe the allocation base to be used for allocating the costs contained within each indirect cost pool to intermediate and final cost objectives
Indirect cost pools should be organized in the accounting system consistent with how costs are proposed when bidding on opportunities. The contractor should account for costs in the same manner in which it proposes costs.
Setting Up Indirect Cost Pools in QuickBooks
Once the company’s indirect cost pools have been identified, you then need to establish the cost pool structure in the QuickBooks accounting system.
To set up QuickBooks for the class method, create a class in the class list for each indirect cost pool structure identified in the indirect cost allocation policy.
If using the chart of accounts approach (preferred) for establishing indirect cost pools, you will structure the QuickBooks chart of accounts according to the company’s indirect cost allocation policy.
First, establish a parent-level account, in the parent account – sub account hierarchy of the chart of accounts, to head up each cost pool. These parent-level accounts identify the cost pool account groupings.
Then, add the subordinate accounts within each cost pool. All indirect cost pool accounts will be expense-type accounts.
To illustrate the concept, a contractor with a Fringe Benefits pool, an Overhead pool, and a G&A pool, will establish a parent-level account for each: Fringe Benefits, Overhead, and G&A. Indirect cost transactions are assigned to a general ledger account that is subordinated within one of these indirect cost pools.
The cost pools should be the only parent-level expense-type accounts in the government contractor’s chart of accounts. All other expense-type accounts should be subordinated into a cost pool account group.
Organizing the Government Contractor Chart of Accounts
This preferred chart of accounts approach can be summarized with the following four steps:
- Identify the indirect cost pools to be established.
- Create a parent-level expense-type account in the chart of accounts for each cost pool.
- Subordinate existing expense-type accounts into the cost pools.
- Create any new accounts needed to build out the cost pools.
The final chart of accounts should reflect the company’s indirect cost pools, as identified by the root parent-level accounts in the expense section of the chart of accounts.
If there are any parent-level expense-type accounts other than those representing the cost pools designated in company policy, some clean-up is needed. Such stray accounts should be deleted, made inactive, or subordinated into one of the cost pools.
The Advantage of a Compliant Accounting System
A compliant accounting system includes not only software, but also accounting methods, policies and procedures, and controls that ensure the business complies with each element of the SF1408.
The company’s chart of accounts and indirect cost pool structure are fundamental to maintaining a DCAA compliant accounting system for federal contracting.
Proper identification and accumulation of indirect costs enables you to logically and consistently calculate indirect rates, regularly determine costs charged to contracts, routinely monitor contract expenditures against limitations on price or cost, and obtain adequate data for pricing follow-on acquisitions. All elements of an adequate accounting system.
When designed to satisfy the requirements outlined on SF1408, the government contractor’s accounting system is prepared for a DCAA Accounting System Review. Once you’ve passed the DCAA audit, your business will be in the position to qualify for new contracting opportunities. Start planning now, so you’ll be ready to win new federal government contracts.