One of the most common topics we address with clients is their billing rate structure. The conversations tend to start in one of two ways. The first relates to a real or perceived competitive pricing issue. The second relates to an accounting system (software) upgrade. In both cases, we train clients how to properly structure pools and calculate rates, as setup is key. Most clients understand the basic concepts, but struggle with nuances, making appropriate updates, or adjusting to their changing business model. Our goal is to help you through the process.
A Primer on Cost Pools
Cost pools are simply a grouping of similar homogeneous accounts. The key here is “homogeneous accounts.” That simply means that only one type of expense is captured in an account (e.g. labor, travel, ODCs, etc). Since accounts are assigned to a cost pool or allocation base, their makeup needs to consist of only one type of expense.
The most common structure is a three-pool approach of Fringe, Overhead, and G&A. While some organizations have more pools or multiple Fringe or Overhead pools, they still boil down to this basic approach. Unless your organization is large; has multiple locations, operating divisions, or product lines; or has separate subcontract management or material handling teams, three pools are sufficient.
Costs collected in the pools are allocated over a related, beneficial base. For example, fringe expenses are allocated over total labor. Fringe expenses include employer taxes, group health insurance, 401(k), etc. The obvious benefactors are employees, so allocating the expenses over direct labor makes sense. You can allocate over direct labor dollars or direct labor hours. I prefer and recommend hours as that data is already captured in your accounting system and is a bit easier to track and manage. And, since most of your other pools will be allocated on dollars, it’s easier to keep everything on dollars. However, as you will see with other cost pools below, allocation bases can be based on machine hours, square footage, or any other reasonable method.
Fringe captures most of the expenses and benefits necessary to attract and retain employees (see Unallowable Items below). Fringe expenses typically include the following:
- Employer taxes – FICA, FUTA, SUTA
- Health Insurance – medical, dental, disability, life
- Retirement – 401(k), SEP, profit sharing
- Bonuses – can be Fringe or another pool
Overhead captures most of the operational expenses of the organization such as indirect labor, supplies, rents, utilities, training, etc. We tell clients to think about the expenses necessary to operate a location, not the expenses necessary to run the company (we’ll get to those next).
Overhead is one of the first pools organizations look to split or expand. For example, an organization with multiple locations may setup a separate overhead pool for each location, especially if the customers/contracts are closely tied to a specific location. Other common separators for overhead include operating divisions (manufacturing vs engineering) and product lines.
G&A captures most of the expenses necessary to run the company. These include executive salaries, accounting, human resources, information technology, professional consultants, etc. G&A type expenses occur regardless of the amount of sales or number of locations. You might also think of these as back office support or corporate expenses.
Unallowable expenses are those defined in FAR 31 or contract-specific items that must be excluded from your indirect rate calculation. To clarify, these are legitimate business expenses that may otherwise be deductible for tax purposes, but are not allowed to be billed back to the government. Common unallowable expenses include marketing, entertainment, alcohol, company parties, and travel in excess of the Federal Travel Regulations and Joint Travel Regulations.
Unallowable expenses are an entire topic on their own. Please see our resource page on DCAA Unallowable Costs or contact us with specific questions.
Separating cost pools comes into play when resources collected within the pool are not shared or used fairly by the allocation base. In other words, the link in the causal-beneficial relationship is broken. Back to our manufacturing and engineering example, one division of the business may be using more of the resources within a pool without bearing their fair share of the burden. You can rectify the problem by creating two pools whereby the associated expenses and allocation bases are separated providing for a better causal-beneficial relationship.
Other ways of separating pools include creation of intermediary pools and handling fee pools. Intermediary pools capture expenses and then allocate them to other pools before the calculation of those rates. Handling fee pools capture administrative-type expenses and allocate them over a specific set of direct costs. Both help organizations achieve better cost and price models through activity-based costing.
Examples of intermediary pools are facilities and information technology (IT). These are resources used by every department or division in an organization, but not necessarily used evenly. For example, G&A departments typically occupy a small portion of office space, whereas manufacturing typically occupies a very large portion of the building. A facilities pool captures rent, depreciation, utilities, property taxes, maintenance, and lawn care, then allocates those expenses based on square footage. Here, square footage is a more reasonable and beneficial allocation base than labor dollars or hours.
Handling fee pools are created for materials or subcontract management where the organization incurs significant expenses in these areas and has separate, dedicated teams that provide these services. Handling fees are added to the cost of those items (for billing purposes) in lieu of Overhead and/or G&A. In typical billing rate structures, direct labor is burdened with Fringe, Overhead, and G&A, while material, travel, ODCs, and subcontractors are burdened with G&A. For some organizations, their G&A rate is not competitive or not fully reflective of the costs associated with administering ODCs and subcontractors, so they setup separate pools.
We recommend you consult with a professional before altering your billing rate structure as these calculations are complex and errors can lead to significant under- or over-billing of clients.