Indirect Cost Series: Part Four – Over/Under Application of Indirect Costs

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This is part four of a five part series on indirect costs.

Audit professionals typically approach financial statement information from an external reporting viewpoint . With most contracts, we review a client’s position as of their year-end date. From a cost accounting perspective, however, contracts should be looked at monthly to determine accurate contract status. This includes comparing actual costs incurred (including direct and indirect costs) to budgeted costs to determine variances. This brings us to the concepts of “under application” and “over application” of indirect  costs. If indirect costs are under applied, it means that the actual amount of overhead exceeded the amount applied for the period, which would be the amount you budgeted for the period . Additionally, indirect costs would be over applied if the actual amount of overhead was less than the amount estimated for. Consider the following scenario:

  • Contractor XYZ budgeted $1,000,000 for estimated allocated indirect costs for Project A, which is a two-year project beginning on January 1, 2015
  • $50,000 was budgeted as indirect costs applied to Project A in January 2015
  • Actual indirect costs allocated in January 2015 were $60,000

Since actual indirect costs allocated to Project A in January 2015 were $60,000 and budgeted costs were $50,000, indirect costs were under applied. As a result, there was an unfavorable variance of $10,000. Note that this additional $10,000 of costs in January 2015 will also affect revenue recognized for contractor using the percentage of completion method for long-term construction contracts. The following scenario demonstrates the implications to the contract:

  • Total Contract Price: $14,300,000
  • Total Estimated Contract Costs: $13,000,000
  • Assume that, in addition to $60,000 in indirect costs, an additional $100,000 in direct costs were incurred in January of year one, which equaled the budgeted amount of $100,000

CREG-Chart-4

  • Note that estimated costs to complete are adjusted upward from $13,000,000 to $13,010,000 to include the increase in allocated indirect costs of $10,000

As you can see, the increase in the costs incurred in January 2015 will increase revenue recognized by approximately $11,000 when compared to revenue recognized in your budget. Comparatively, this is not a large acceleration of revenue recognition as compared to the budget. However, it is very important to employ good estimating and budgeting techniques to ensure that variances are minimal when compared to budgets to accurately project the status of contracts and to ensure that profit is maximized on projects.

Our final article in this indirect cost series will focus on miscellaneous indirect cost items that all contractors should be aware of for their projects. For more information on indirect cost application in budgeting, please contact Chris Fischer of Aronson’s Construction and Real Estate Group at 301.231.6200.

About Christopher Fischer

Christopher Fischer has written 5 post in this blog.

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