Unraveling the web of indirect rates can be tough, especially for government contractors. At times it can be a balancing act between building informative budgets, crafting competitive bids, and allocating actuals costs incurred, all while juggling regulatory compliance. Here are some key considerations for GovCons:

“Mind the gap”

Carefully crafted budgets help businesses pave the way for success. From resource planning to goal setting, budgets help drive key business decisions. When developing an annual budget, organizations often focus on expenses directly attributable to products or service offerings – while paying little attention to the “other expenses”. Using less precise methods to budget indirect costs creates a gap in the budgeting process. The bridge for this gap? Indirect rates.

Acting as a mechanism to allocate costs, indirect rates should equitably distribute costs throughout the organization and to direct projects. As indirect costs tend to be a substantial portion of an organization’s total costs, indirect rates are essential to understanding the true cost of doing business. Indirect rates paint a wholistic picture of an organization’s true costs and help to predict future costs during the budgeting process. Indirect rates are also an effective tool when calculating total project costs and developing project budgets for future years.

The power of pricing

Final pricing decisions for contract types like Firm Fixed Price (FFP) and Time and Materials (T&M) are significantly influenced by indirect rates. To wield the power of pricing you must have a basic overview and understanding of indirect rates. Overestimating indirect costs can inflate bids and potentially lead to lost opportunities. Underestimating indirect cost may cut into profit margins or result in financial losses.

By developing an appropriate indirect rate structure, indirect expenses are allocated proportionally to each project, or government award. Knowing the equitable allocation, or “fair share”, of indirect costs for a given project assists in pricing competitively while staying above the bottom line.

Masters of (Indirect Rate) architecture

Mastering the art of indirect rate structures is no easy feat. Before diving into the design principles of rate structures, one must understand the foundational building blocks and common groupings. Indirect cost rates are frequently calculated as the ratio between indirect expenses and a cost base while maintaining a casual beneficial relationship. This ratio forms an indirect rate, applied as a percentage, to allocate indirect costs to the cost objective.

Common classes of direct costs include:

• Direct labor
• Direct subcontracts
• Direct materials
• Other direct costs (ODC’s)

Common indirect cost pools include:

• Fringe benefits: Includes employee related welfare expenses and payroll taxes
• Overhead: Costs generally associated with the direct support of two or more contracts (or functions)
• General & Administrative (G&A): Expenses necessary to run the organization or business unit, which benefits the entity as a whole

The number, and variations, of cost pools often depend on the structure and complexity of an organization. Cost pool variations might include the addition of a material and/or subcontractor handling rate, or even separate overhead pools based on service offerings, product lines, or location.

The art of allocation

When establishing indirect rates, grouping similar indirect costs into logical and homogeneous pools is key. Some expenses might be grouped together because they share the same or similar relationship to the allocation base (a common driver for allocation). In other instances, all indirect costs identified with an activity might be accumulated into a cost pool. In either case, it’s important to thoroughly understand how incurrence of one cost impacts the incurrence of another cost.

Selecting an appropriate allocation base is vital to helping ensure accurate and equitable cost allocation. Being able to illustrate a clear cause-and-effect relationship to the allocation base is essential. Often the allocation base selected might be clear cut, such as direct labor costs, direct materials, or total cost input. Allocation base selection becomes a bit more challenging when indirect costs benefit both direct and indirect cost objectives, or benefit multiple areas of the organization to a different degree. In these instances, exploring the possibility of developing an intermediate expense pool or service center might be warranted.

Service centers/Home office allocations

Services centers and home offices are typically departments or functional groups that perform activities or work which benefit multiple departments, functions, or other cost pools. Service centers could also perform activities which benefit multiple contracts as well.

• Service center allocation bases can often recognize the variable cost utilization such as consumption, usage, or output. Standard metrics can also be leveraged including square footage, headcount, or documented usage.
• Home office is allocated based on Three-Factor Formula. Per Cost Accounting Standard 403, this formula uses the average of segment payroll dollars to total payroll dollars, operating revenue to total operating revenue, and percentage of the average net book value of the sum of the segment’s tangible capital assets plus inventories to the total average net book value of such assets of all segments.

When implementing service centers and home offices, organizations must evaluate the significance of costs and mechanisms for allocation while considering the administrative burden and complexity of managing multiple service centers.

Careful consideration

Formulating an optimal indirect rate structure can maximize an organization’s ability to recover allowable, allocable, and reasonable costs. However, be wary of the indirect rate structuring pitfalls. Consider the following when determining what structure is right for your organization:

• Cost allocation structures should enhance visibility into internal reporting and government required indirect rate calculations.
• The organizational setup, centralized or decentralized structure, and diversity of service or product offerings should drive how complex an indirect rate structure needs to be; Keep it simple.
• Monitor actual cost performance and consider whether unexpected variances indicate that a change to accounting practices is needed.
• Adjust billing rates if there are significant variances and are no longer representative of final year end rates.
• As government contractors are expected to adhere to regulatory requirements, make sure to always consider compliance in your indirect cost decisions and understand the changes in cost relationships or business conditions.

While we’ve covered the key points to know in this article, our webinar, “Unraveling the Mysteries of Indirect Rates for GovCons”, goes deeper into deciphering indirect rates. For a more immersive education, and a deeper dive into regulatory considerations, we recommend tuning into the entire program. Doing so may provide valuable answers to your most pressing questions.