One of the most common topics we address with clients is their indirect 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. If they contain multiple types of expenses, they cannot be easily assigned to the appropriate pool or base.
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 dollars 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 perform all calculations based 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. 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
All W-2 employees benefit from your fringe pool, so all W-2 employee labor is included in the base. Note the "W-2" aspect of labor - no temporary or contract labor - only employees who receive a paycheck from your organization.
- Direct Labor
- Overhead Labor
- Training Labor
- G&A Labor
- B&P Labor
- IRAD Labor
- Unallowable Labor
The most common issue we see is that labor does not match the 941 quarterly tax returns. Part of the Incurred Cost Submission (Schedule L) is the reconciliation of labor to the 941 quarterly tax returns. Labor either ends up co-mingled in an account with non-labor expenses or ends up in an account with a title or description that does not clearly identify it as labor. Best Practice: Use the term "Labor" in the name of every labor account.
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.
Since overhead expenses are related to operations, the typical base is direct labor. If you maintain separate fringe and overhead rates, you'll need to apply the related fringe to direct and direct-type labor in your overhead base:
- Direct Labor
- Applied Fringe on Direct Labor
- B&P and IRAD Labor
- Applied Fringe on B&P and IRAD Labor
- Unallowable Direct Labor
- Applied Fringe on Unallowable Direct Labor
Overhead issues we typically see usually result from inconsistent treatment of costs. For example, companies will sometimes treat an expense as direct and sometimes as overhead. While there are very limited legitimate reasons to do this (i.e. when a contract calls for an item to be directly delivered), costs must be consistently treated the same way. A related issue we see is the treatment of costs sometimes as overhead and sometimes as G&A. With very limited exceptions, costs fall into one pool or another, not a best guess each time you incur them. Best Practice: Treat costs consistently. During an audit, you'll have less of an issue for consistently treating a cost wrong than if you frequently change the way you treat a cost.
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.
Many organizations use a total cost input (TCI) approach to G&A. This simply means that they apply G&A to all non-G&A expenses. It's the easiest and most fair approach to applying G&A. Some organizations use a value-added model where G&A is applied only to direct costs. This approach results in a higher G&A rate (applied over a smaller base) and implies that all G&A activities more directly benefit those direct costs.
The two most common issues we see with G&A rate calculations are costs missing from total cost input and incorrect treatment of B&P and IRAD. B&P and IRAD are treated as if they are direct costs and therefore bear applied overhead. Best Practice: Use a validation tool to ensure all costs are included either in the G&A pool or G&A base.
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 costs. 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 indirect rate structure as these calculations are complex and errors can lead to significant under- or over-billing of clients.
Free Indirect Rate Calculator
In order to help you calculate or verify your rates, we're providing this free indirect rate calculator. The free version is setup for the three basic pools of Fringe, Overhead, and G&A. If you need help with a more complex calculation, call or email today!