A Guide to Understanding Indirect Costs and Indirect Rate Structuring

Introduction to Indirect Costs & Indirect Rates

Whether your company is small start-up, privately held or a publicly traded company understanding your indirect cost structures is critical to long-term financial success. Any firm wishing to doing business or contracting with the government needs to understand that compliance with the extensive Federal Acquisition Regulation (FAR) and Defense Federal Acquisition Regulation (DFAR) frameworks requires the submission of indirect rates. One of the most important areas of compliance is the design, structuring, implementation, and maintenance of a firm’s indirect cost rate structure. ?A correctly designed and implemented indirect rate structure can give a company a strategic advantage. A thorough understanding of the true costs of a contract is vital in building up costs to support the development of contract pricing.

One of the key building blocks for a government contractor’s accounting system is the allocation of costs across several different contracts.?This requires the identification and proper segregation of direct and indirect costs and the determination of cost pools for many different contracts.?(2) In the current contracting environment, it is vitally important to design the most competitive indirect cost rate structure that helps ensure winning the contract. Understanding all aspects of a firm’s cost pool is vital for a contractor to succeed in increasing competitive bid situations and remain profitable for the long-term.

The indirect rate structure that a contractor develops should ensure that all indirect costs are allocated in a manner that is consistent with their benefit, without being too complex to structure or labor intensive to manage or administer. (3) Contractors need to be consistent in categorizing costs in order to effectively monitor escalating costs which can erode profit margins. (4) Companies will determine the number, structure and composition of indirect cost pools and the indirect rate structure.

This article was developed to provide the reader with a thorough and broad understanding of several key issues related to indirect costs and the development of an indirect rates structure, including the following topics:?

Direct Costs vs. Indirect Costs

A contract price is composed of two key parts; the costs plus the profit margin for product or services provided by the contractor. The costs in turn can be broken down to two sub-components.

1)??????When a contractor incurs an expense, it is either a direct cost that can be identified with a specific contracts.

2)??????Or it is an indirect cost that benefits multiple cost objectives, contracts or the firm. If one did not have a specific contract and would still incur the cost then it is an indirect cost.

FAR requires government contractors to develop and follow guidelines for distinguishing between direct and indirect costs. (3)

The table to the below shows the various standard components of direct and indirect costs. (7)

Direct Costs

Direct costs?are costs that are specifically identifiable to one cost objective, one product or deliverable service. These typically include labor, materials and direct subcontractor costs. Direct costs are costs that can be associated with or traced to a particular cost object and processed in an economically feasible way.

Indirect Costs

After direct costs have been determined and charged directly to the contract a company needs to determine its indirect costs. Indirect costs are any remaining cost not directly identified with a single final cost objective, but identified with at least one intermediate cost objective or two or more final cost objectives.

The indirect cost structure developed will be highly dependent upon the nature of the contractor’s business environment. While indirect costs are an important consideration in the analysis of every cost proposal, the share of cost that they represent will vary from firm to firm and industry to industry. For example, indirect costs will represent a larger share of a cost proposal for a heavy equipment manufacturer than for a contract services provider. A heavy equipment manufacturer will usually have a substantial investment in plant and equipment and other overhead that cannot be directly charged to any one product, and thus is considered an indirect cost. (9)

Once indirect costs are identified they must be distributed to contracts in reasonable proportion to the benefits received. This distribution is achieved through the use of indirect costs rates. The purpose of an indirect cost rate is to allocate allowable indirect costs to contracts in a equitable and fair manner. (3)

The FAR gives no substantial guidance or direction into how companies develop their indirect costs pools. Contractor can divide and stratify indirect costs pools in different manners. However, they must be consistent and methodical on how they classify and structure indirect costs pools. In more complicated government and defense contractors, some indirect costs are collected in intermediate pools and then allocated further to the final indirect pools. (5) The number of indirect cost accounts at single firms can range from as few as a dozen to as many as several hundred depending on the size of the firm, number of contracts, and nature of their business.

Understanding Cost Structures

Indirect costs structures can be quite complex, so understanding their underlying structures is important. Some of the key factors to consider include the following: (7)

Indirect Cost Pools

In order to calculate an indirect cost rate, a company must first group all indirect costs into distinct indirect cost pools. FAR’s only requirement is that the allocation of indirect costs must be reasonable, fair, consistent and equitable. This allows a firm a great deal of leeway in determining where certain costs will be included in a given indirect rate structure. (3)

An indirect cost pool is a structured grouping of indirect costs with a similar relationship to the cost objectives. For example, manufacturing overhead pools will include indirect costs that are associated with all manufacturing efforts. Defining well-structured indirect cost pools and rates will not only insure a company is compliant with government regulations, but also help ensure that it is maximizing profitability when bidding on new contracts.

A well-developed indirect cost pool, should allow for the allocation of the included costs in a manner similar to the allocation that would occur if the firm allocated each indirect cost independently. Understanding how indirect costs flow into indirect cost pools and are allocated to contacts is critical to success for contract pricing. (3)

The indirect cost pools used to make the final allocation of indirect costs to cost objectives are unusually called primary pools. A secondary pool is an intermediate pool composed of a subset of costs that is used to allocate costs to primary pools. Most indirect pools contain 5 to 8 accounts that drive 70 to 85 percent of the costs in that pool. (7)

The diagram below exhibits things to remember to better understand indirect cost pools: (7)

Indirect Costs Allocations

Once indirect rate pools have been created, each one must be appointed an allocation base so that an indirect rate may be calculated. An allocation base should result in an intelligent, consistent and reasonable allocation of costs to contracts. For example, total labor cost is an appropriate allocation base for a fringe rate pool because of the clear relationship between the two. The contractor needs to select an allocation base that is common to all cost objectives to which the grouping is to be allocated. The base period for allocating indirect costs is the cost accounting time period during which such costs are incurred and accumulated for allocation to work performed in that period.

In order to select an allocation base for the indirect cost pool, a company needs to consider the type of indirect costs in the pool, and whether the allocation base will provide a credible representation of the relative utilization of pooled indirect costs by direct cost activities. Each allocation base should represent the full spectrum of activities supported by the pooled indirect costs. The following represents some of the more common allocation bases that are typically used to allocate indirect Cost:?

The type of base allocation determines whether the indirect cost rate will take the form of a dollar rate per unit of measure or percentage metric. For example, some common manufacturing overhead indirect cost allocation bases are as follows: (9)

The larger a contracts share of the allocation base for the accounting period, the larger the contract's share of the related indirect cost.

Indirect Rate Structure Complexity & Modeling

Indirect rates structures can be single-tiered or multi-tiered in design or structure. Single-tier indirect rates structures are usually utilized by contractors with simple costs structures and with relatively few contracts. In a multi-tiered indirect rates structure indirect costs are allocated in a hierachy structure to other costs, and finally to the allocaiton base to develop the cost pools. Most large government and defense contractors have multi-tiered indirect rate costs structures because of the large number of contracts and the diverse nature of their business activities These structures are very complex and outside the scope of this article. (8)

If a company is modeling its indirect rates structures using primarily spreadsheets, then I guarantee there is probably at least one error if not several in in the indirect rate pool structures or allocation calculations. While spreadsheets allow you flexibility in the initial development period of indirect costs rates structures, there is a high probability that the allocations or pool development processes will contain errors. If a company has multi-tiered rates structures, modeling indirect rates in spreadsheets becomes even more difficult. Industry best practices is to develop indirect rates utilizing sophisticated accounting and pricing systems that can track your indirect costs firm wide, develop multi-tiered structures, pools and correctly allocate them to the proper costs bases.

Types of Indirect Rates

Indirect costs pools are usually groups into one of three sub-classes which are as follows:

The definition of fringe costs are very clear but overhead and G&A have a somewhat less clear definition.

Fringe

Fringe?costs are those costs related to employing a company’s labor force or workers. Some common examples of fringe costs include: (4)

The allocation bases commonly used for fringe is direct labor or total labor costs.

General & Administration (G&A)

The General and Administrative (G&A) costs pool consists of those expenses related to the overall running and management of the company. G&A expenses are the residual costs necessary to run a business, regardless of whether the firm has government or defense contracts. These are the management, financial and other expenses related to the general administration of the business as a whole. Items such as human resources are divded between G&A and overhead cost pools based on the number of employees (headcount) assigned to those particular cost centers. G&A expenses will vary widely from firm to firm due to the size of the firm and the complexity of their business operations.

Some typical G&A costs include: (4)

The G&A rate also includes a portion of allocated fringe indirect costs. The G&A rate allocation bases commonly utilized are Total Cost or Total Labor Costs.

Overhead

Overhead cost pools contain cost items that cannot be billed directly to a particular contract, but can be attributed to the cost of doing business with one or more customers. Some overhead costs centers will accumulate a pool of costs that are related to the work activity of the direct labor employees. Direct labor employees will require support costs such as supervisory salaries, other indirect salaries, office supplies, equipment, building utilities, training, payroll taxes, insurance, lease or rent, depreciation of buildings and equipment, and maintenance of building or factory space. Other ovehead costs centers will be based on pools of costs related to a quantity of units produced or raw materials utilized Overhead costs also include proportionate share of office buildings or service center costs including lease payment, technology services, computer equipment and telephone costs, etc. (8)

Depending on the complexity of the company, overhead may be grouped into one general overhead category or sub-divided into smaller overhead costs pools including: (5)

The site overhead pool is also commonly split further to divide on-site and customer-site employees. This is because it costs more in overhead costs to employ someone who works on a company site than someone at a government site. It isn’t fair to allocate and charge costs for company site employees to government clients who are providing materials such as computers, office materials, desks and office space to workers. (1)

Below are typical indirect costs included in the various overhead pool types: (7)

Indirect Cost Rates Calculation Methodology

The basic indirect formula is a follows:

The indirect cost rate is calculated by dividing a pool of expenses (numerator) by an allocation base (denominator) such as total labor cost. The allocation base selected can be something other than a monetary cost such as machine hours or facility square footage. The expense pool represents indirect costs accumulated by logical groupings, and distributed on the basis of benefits accruing to the several different cost objectives. This means that the existence of the base and the employment of the base activities creates the pool of expenses over a period of time. The same cost cannot be include both in a pool and an allocation base.

There is a direct relationship between indirect rates and indirect cost pools. As the pool costs increase, the indirect rates increase. Contractors must strive to keep the pool costs as low as possible in order to have rates that are as competitive as possible. (6) Calculating costs can become complicated because the rate charged on direct labor is a percentage of the indirect costs pool divided by the direct labor allocation base. So if a company’s direct labor costs are lower than forecasted, the indirect pool costs will need to be lower to maintain the forecasted indirect percentage rate. If a company’s direct labor rate is greater than the forecasted, the indirect pool costs must also be higher or the firm will have to make payments back to the government at the end of the contract year. Thus, it is strategically important to track both direct and indirect costs closely so adjustments can be made as needed during the contract period. (1)

Indirect Cost Rate Calculation Example

Once a company has divided costs into their various pools, indirect rates can be calculated. The charts below show a very simplified example of indirect rates calculations for fringe, G&A and overhead indirect costs. Note, the overhead indirect costs calculations including manufacturing, materials, engineering and service overheads. Not all firms will have all of these categories, nor will all firms break them out to this level of detail or in this manner. Some firms will usually separate out service overhead into on-site and offsite. The figures utilized in this charts are purely for example only.

The calculation of pool costs is as follows:

The calculation of allocation bases is as follows:

The calculation of final indirect rates is as follows:

Indirect Rate Volatility and Fluctuations

Indirect costs are sometimes a large percentage of a program’s total contract costs. Variances between the budgeted indirect rates and actual rates incurred can create funding risks that may cause contract delays, underfunding or even project cancellation. There will always be differences between the forecasted rates during the contract year and the actual rates at year end. The estimated indirect rates need to be recalibrated when large differences occur on a regular basis. The impact of these recalibrations for companies with largely cost-reimbursable contracts are as follows:

• Over-running rates occurs when the actual rates are greater than the approved or estimated rates. The firm can bill the government for the shortfall. A company must carefully weigh the benefits in determining whether or not to bill for indirect rate over-runs. There may be no funding available to make up for the short-fall.
• Under-running rates occurs when the actual rates are lower than the estimated or the approved rates. The firm will have to reimburse the government for excess cash collected. (3)

As the table below shows there are several causes of indirect rates fluctuations: (7)

Indirect Rate Multiplier

The indirect rate multiplier represents the effect of burdening one dollar of direct labor with all of the indirect costs of a company using its established rates and allocation bases. The indirect rate multiplier is as follows: (9)

For example assume a firm has the following indirect rates profile

• Fringe = 30%
• ?G&A = 15%
• Overhead = 25%

The indirect rate multiplier in the above example is:

Indirect Rates Types through the Contract Process

The various types of indirect cost rates include predetermined rates, provisional rates and final rates. Indirect rates play a vital role in the government contract pricing and the long-term financial well-being of a firm.

Forward Pricing Rates

• During the contracting process, a contractor proposes forward pricing rates and uses these rates in contract proposal pricing used to submit a bid on contracts. The estimates are often developed over several years, based on previous contracts and experience. The forward pricing rates developed should replicate the final indirect rates pricing structure. The estimates should be reasonable and reflect the latest available cost data. (9)

Provisional Billing Rates

• Provisional billing rates are indirect cost rates used to bill the government on cost-reimbursable contracts. Initially, these rates are different from the actual rates incurred over the course of the contract year. Over time these rates should become more accurate as more actual cost data becomes available. Companies strive to stay within the budget, but things happen and the actual numbers do not exactly match the budget. At the close of the contract after a reconciliation, a firm will either owe the government a refund (if actual rates were lower than budgeted) or will need to bill the government (if actual rates were higher than budgeted). Provisional billing rates should be as close as possible final pricing rates. (1)

Final Indirect Rates

After the accounting period is completed, contractors can calculate actual incurred indirect cost rates. These final rates are then submitted to government or agency for final agreement before final contract payments are made.

The chart below shows the traditional relationship of forward pricing, billing, and final rates. (3)

Indirect Rates Analysis

Because indirect costs affect a number of contracts, a company must be very methodical on the identification, allocation and structuring of indirect costs and indirect rates. The following flowchart depicts the key events that must be followed as part of a typical indirect rates structure to ensure that they are reasonable and sound.?

Questions to Ask During the Indirect Rate Development Process

The indirect costs rate assessment and indirect rate structuring process can be quite challenging for some firms. It can be very helpful to make sure that all of the questions below are fully answered and understood to ensure development of a viable and consistent solid indirect rate structure.

Changes in the Indirect Rate Structure

Over time as the nature, size and structure of a government or defense contractor changes the company will need to change or adjust the indirect rate structure to suite their new operational environment. Some common causes for these changes include: (7)

Conclusion and Final Thoughts

There are historical trends or benchmarks for indirect rates for certain industries. However, they should only service as general guidelines in indirect rate structuring. (6) To better understand a company’s indirect rates, one needs to look at the firm’s entire cost structure and scope of business. A firm needs to understand the major drivers of fringe, G&A, overhead costs and how to correctly allocate them into indirect cost pools.

A company must have appropriate accounting systems and practices for identifying, capturing and allocating indirect costs in the development of indirect rates. A firm must remember not to make it’s indirect rate structure too complex or the time and money spent to maintian it will far exceed the benefits. Companies must assess their indirect cost rate structure and identify areas of potential non-compliance. If a company doesn’t have the internal expertise to develop indirect rates then it should hire an external accounting or consulting firm to guide it through the process.

A correctly designed and implemented indirect rate structure can give a company a strategic advantage. A thorough understanding of the true costs of a contract is vital in building up costs to support the development of contract pricing. Failure to properly allocate indirect costs will result in improperly priced proposals and a greater chance of losing a contract bid. As a business changes over time, the indirect rate structure needs to be constantly revaluated so that the indirect rate structure remains viable and optimized. A government contractor’s long-term success lies in its ability to develop and maintain an effective indirect cost structure that is FAR/ DFAR compliant and maximizes it probability of win (P Win) for new contracts. (3)

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