Calculating Indirect Rates for Government Contracts
As a government contractor, you must track direct and indirect costs and allocate them to your contracts. Direct costs are fairly straightforward. They support a specific business objective or contract. Many contractors struggle with tracking indirect costs, which benefit multiple contracts, business objectives or the company as a whole.
Contractors typically group indirect costs into pools of related expenses. The three broadest categories are:
- Fringe costs to maintain W-2 employees such as taxes, health insurance and retirement.
- General and administrative costs incurred in running the overall business.
- Overhead costs such as indirect labor, supplies, rents, utilities, training, etc. needed to run an office or location involved in fulfilling a contract.
Depending on the size of your company and the number of government contracts, you might need to set up multiple pools for various subcategories. According to FAR 31.201-4, contractors must allocate indirect costs to contracts in reasonable proportion to the benefits received.
Cost Pools
Cost pools (groupings of G/L accounts) must be homogeneous (like costs incurred for the same reason or purpose). Commons cost pools include:
- Direct
- Fringe
- G&A
- Overhead
- Unallowable
Cost Pool Composition
Direct
Direct costs (aka Cost of Goods Sold (COGS)) are those costs directly attributable to a final cost objective (e.g. contract, job, project, product, or service).
Cost elements include:
- Labor
- Materials
- ODCs
- Subcontractors
- Travel
Fringe
Fringe costs are those to maintain W-2 employees. Two key words are “maintain” and “W-2.” “Maintain” refers to the fringe benefit expenses incurred after hire. Job posting, interview, and other HR costs are part of G&A. “W-2” refers to the employees of your business and specifically excludes temporary labor, subcontractors, and 1099 contractors.
Cost elements include:
- Employer taxes
- Health insurance
- Paid absences
- Retirement
Overhead
Overhead costs are those to support multiple customers, products, or services, or where the costs cannot be easily allocable to final cost objectives. This includes cost amounts that are immaterial in nature.
Cost elements include:
- Facilities (may be a separate pool)
- Indirect labor (supervisors, admin, training, & idle time)
- Shop supplies
- Training
General & Administrative (G&A)
G&A costs are those to operate the business as a whole. We typically say these are costs incurred regardless of number of customers or products.
Cost elements include:
- Enterprise software
- Indirect labor (accounting, business development, HR, IT)
- Professional fees
- Taxes and licenses
Unallowable
According to FAR 31.201-2, unallowable costs are those costs deemed unallowable by the government based on:
1. Reasonableness.
2. Allocability.
3. Standards promulgated by the CAS Board, if applicable, otherwise, generally accepted accounting principles and practices appropriate to the circumstances.
4. Terms of the contract.
5. Any limitations set forth in this subpart.”
Please see our resource on FAR 31 and Unallowable Costs for more information.
Acceptable Allocation Methods
Once pools are established and costs are collected, they must be allocated to final cost objectives (e.g. contracts, jobs/projects, products, services) using an acceptable allocation method based on a logical causal-beneficial relationship. This means there must be a logical relationship between the pool and base.
For example, fringe costs allocated over all W-2 labor, because fringe is incurred to maintain W-2 employees.
Direct
Direct costs are assigned to their proper final cost objective (e.g. contract, job/project, product, service) at the time of incurrence.
Fringe
Fringe costs can be allocated using one of four acceptable methods:
1. Total W-2 labor dollars – this approach allocates fringe over direct and indirect labor dollars (allowable and unallowable). This is the most common method and our recommendation since it is the most fair and generates the least amount of variances.
2. Total W-2 labor hours – this approach allocates fringe over direct and indirect labor hours (allowable and unallowable). This is the least common and not recommended because of the extra work necessary to estimate total hours worked by employee and the high risk of over- or under-absorption of costs based on actual hours worked (as compared to option #1 which maintains a steady rate regardless of the number of hours worked).
3. Direct W-2 labor dollars – this approach allocates fringe over only direct labor dollars. This approach is common (even required) in some industries such Architect/Engineer (A/E). While this is an acceptable method, users lose visibility into the full relationship of fringe costs and labor costs since only a portion of labor costs are in the base. This method is also subject to swings in rates due to seasonality of labor or other significant shifts of labor between direct and indirect (e.g. during a downturn in business or lag between contracts).
4. Direct W-2 labor hours – similar to #2 in that the allocation is over hours instead of dollars, and #3 in that it only involves direct labor.
Overhead
Overhead costs can be allocated using one of six acceptable methods:
1. Direct labor dollars – this method allocates overhead costs over direct labor dollars plus applied fringe (see “Math of Indirect Rates” below) and is the most common approach, especially in service or high labor industries.
2. Direct labor hours – similar fringe option #2 above, overhead costs are allocated over direct labor hours plus applied fringe. Similar to fringe options #2 and #4 above, the need for accurate estimation of total hours worked leads to higher risk of over- or under-absorbing (aka billing and fully recovering) overhead costs.
3. Direct material costs – this method is useful when material costs significantly outweigh labor costs and may be beneficial to a reseller of products, especially one with a significant amount of drop-ship inventory.
4. Total prime costs (direct labor + applied fringe + direct materials) – reflects value added to the materials such as some assembly or manufacturing environments.
5. Units of production – this method is useful in a high volume production environment. Multiple rates could be developed to support multiple production or assembly lines.
6. Machine hours – this method is useful in a highly automated or heavily machined environment.
G&A
G&A costs can be allocated using one of two acceptable methods:
1. Total Cost Input (TCI) – this is the most common method and allocates G&A costs over most other costs including direct, fringe, and overhead. While this is referred to as total cost input, the base does exclude unallowable G&A costs; unrecovered fringe and overhead (see below); the portion of fringe included in the G&A pool; and the portion of overhead applied to B&P and IRAD costs included in the G&A pool.
2. Value-Added – this method is less common and usually only used in conjunction with a Material & Subcontract Handling (M&SH). While this method could be selected without an M&SH pool, it’s likely to be questioned by auditors.
Unallowable
Unallowable costs are not allocated, but some are in included in the base of overhead and G&A as appropriate. See our Resource on Unallowable Costs for more details.
The Math of Indirect Rates
Rates are calculated by dividing the pool by the base:
Pool / Base = Rate
The building of burden or wrap rates (the adding of fringe + overhead + G&A) is really multiplication. Since the rates are calculated by division and include costs from other pools, top-level rates are built through multiplication. This means that indirect costs follow the base when used in the calculation of another rate. For example, fringe is allocated over all W-2 labor, so fringe is applied to labor when included in the pool or base of another rate. For overhead, this means that fringe is applied to overhead labor in the pool and direct labor (when selected) in the base.
We’re often asked, “Are my rates high or low?” Rates are not inherently high or low. If the composition of the pools and bases are accurate (homogeneous in nature and exclusive of unallowable costs) and the allocation method is acceptable (logical causal-beneficial relationship), the the rate is the rate.
Full Cost Recovery
In order to maximize profitability, contractors must achieve full cost recovery which includes:
Reviewing rates regularly (monthly)
- Actual to budget
- Review variances
Adjusting budget quarterly
- Adjust spending to match billing rates
Monitoring over- and under-billing
Updating billing rates
- Annually for new budget
- As needed for significant changes in the budget
- New or lost contracts (direct costs)
- Increased or decreased expenses
Why Advanced (Multiple) Indirect Rates
Complex organizations often need more than one indirect rate structure. Complexity comes in the form of multiple product or service lines, multiple operating locations, or multiple divisions (e.g. manufacturing & engineering).
The number one complaint from clients: we’re losing money on _____.
- A particular contract
- A particular product
- A particular service
Advantage of Multiple Indirect Rates
Multiple indirect rates lead to better alignment of cost pools and bases resulting in improved profit margins.
B&P and IRAD
B&P – Bids & Proposals – pen to paper response to RFP/Q
IRAD – Internal Research and Development
Some companies encounter the need to capture B&P and IRAD costs before more advanced indirect rate needs.
B&P & IRAD:
- Included in G&A pool
- Treated as direct expense so they receive applied Overhead
- Proper calculation of G&A is tricky as Overhead applied in G&A pool and removed from G&A base
Advanced Indirect Rate Structures
Advanced indirect rate structures involve splitting apart existing cost pools. You may also think of this as adding new cost pools. Some common approaches include:
- Moving facilities from overhead to a separate pool
- Moving IT from G&A to a separate pool
- Splitting fringe
- Splitting overhead
Intermediate Cost Pools
Multiple Fringe
Separate fringe pools for separate groups of employees with different benefits
- Government vs Commercial (different business units or operating divisions)
- SCA vs Non-SCA
- Union vs Non-Union
You must have legally defined and segregated groups of employees. In other words, you cannot discriminate by violating labor laws.
You must have written plans the provide significantly different benefits.
Facilities
Often one part of the business occupies an unfair portion of the building, but pays a lower allocated cost. Facility costs may be captured in a separate pool and allocated over square footage.
- Rent
- Depreciation
- Utilities
- Repairs & maintenance
- Taxes
- Insurance
- Labor
IT
Often one part of the business utilizes an unfair portion of the IT resources, but pays a lower allocated cost. IT costs may be collected in a separate pool and allocated over number of users/employees, devices, or network connections.
- Labor
- Hardware
- Software
- Communications (telephone and internet)
Multiple Overhead
As noted above, overhead may be split into separate pools based on a number of factors, or even a combination of factors.
Separate office locations
- Cost of doing business in San Diego, CA is vastly different than Dayton, OH
- Cost pools aligned with direct costs associated with each office
- Employee based in San Diego, CA is more expensive than one based in Dayton, OH
Separate operating locations (client site vs contractor site)
- Cost of employee based at client site is cheaper than contractor site
- Client is already paying rent, utilities, maintenance, repair, equipment, etc
- Government does not like paying contractor OH for employees based at government site
Not a requirement, but often becomes an issue in long-term contracts and/or when multiple employees involved.
Separate operating divisions (manufacturing vs engineering)
- Cost of manufacturing is significantly higher than cost of engineering or services
- Depreciation, repairs, and maintenance
- Engineers need a PC and a cubicle
- Think of all the manufacturing machinery and equipment
Single overhead rate results in non-competitive (overpriced) service and underpriced manufacturing.
Separate product or service lines
- Cost of some products or services are higher than others
- Special equipment, testing, coating, painting
Single overhead rate results in non-competitive (overpriced) products or services and underpriced products or services.
Any combination of the above!
Not uncommon for a company to have:
- Manufacturing rate
- Material & Subcontract Handling combined with Valued Added G&A
- Offsite services rate
- Onsite services rate
Material & Subcontract Handling (M&SH)
M&SH is a quasi G&A pool made up of cost primarily from overhead and a base from a portion of the G&A base.
Some contractors process a significant amount of materials and/or subcontracts on behalf of the government. Those costs are typically burdened with G&A. G&A rates can get out of control (>~25%) and clients will question the value of the “management and administrative fee.”
- Contractor then moves all costs of administering materials and subcontracts to a separate pool allocated over the direct materials and subcontractors (typically Overhead costs)
- The costs are usually nominal in comparison to a base of significant material and subcontract costs (a portion of the G&A base) resulting in a lower rate
- This rate is used only for materials and subcontracts
This results in a value-added G&A rate (vs Total Cost Input) since you’ve now separated some of the overhead and G&A costs (pool) and segregated the direct costs (base).
Important Note
Contractors can always negotiate a M&SH fee that is less than their G&A without creating a separate M&SH pool.
Requirements for Multiple Indirect Rates
You must have cost pools and bases that are clearly defined and easily segregable:
- This means costs easily assignable to a group of employees, locations, products, or services
- And bases that are easily segregable from other bases (e.g. direct mfg vs direct engineering)
For example, from a single overhead rate:
- Engineering costs are allocated over engineering direct labor (engineering overhead)
- Manufacturing costs are allocated over manufacturing direct labor (manufacturing overhead)
You must have a general ledger structure that aligns with your new structure. This means new G/L accounts, codes, classes, tags, etc.
You must have tools to aid in cost collection
- This means timekeeping, expense reporting, requisitions, and purchase orders
You must have significant costs to achieve the benefit of splitting pools.
You don’t do this to shave off a few percentage points.
Basic math of splitting cost pools and creating multiple indirect rates:
One rate will go up and one rate will go down.
This is no small task and not for the faint of heart.It’s not rocket science, but requires a significant amount of design, implementation, and maintenance.
How We Can Help
If you struggle with tracking indirect costs, you’re not alone. It’s one of the most frequent topics our experienced GovCon accountants cover with clients. We can-
- Answer your questions about indirect costs and your federal contracts.
- Assure that your accounting system is set up to allocate direct and indirect costs correctly.
- Help you and your team set up indirect cost pools.
- Assist you with calculating indirect cost rates.
- Provide you with an online tool that calculates indirect rates.
- Prepare for and defend against DCAA and DCMA audits that include your allocation of indirect costs.
Video Training Resources
Additional Resources
- LBP Website Resources:
- Resources: Indirect Cost Pools
- Tool: Indirect Rates-Use our rate calculator spreadsheet to learn how to compute indirect rates. Access our indirect rate calculator.
- Federal Government Resources: DCAA: FAR Cost Principles Guide
Ready to get more information?
Contact us now or schedule one-on-one time to learn more about indirect rates in government contracts – and how we can help you manage cost reporting for maximum profitability.