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 include 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. are needed to run an office or location involved in 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.
Types of Rates
Let’s start with a primer on the types of rates you’ll hear and read about in this industry.
- Burden Rate – the multiplier of your costs (Fringe, Overhead, and G&A) before profit or fee. This is your break-even rate.
- Wrap Rate – the total multiplier of your costs plus profit or fee.
- Budgeted Rate(s) – these are the budgeted rate(s) (individual or collective) based on the enterprise budget. Budgeted rates may be updated as we discuss later in the book.
- Provisional Billing Rate (PBR) – the agreed-upon (“approved”) rate for billing on a contract. This may be a blanket rate used across multiple contracts or the negotiated billing rate on a specific contract. These come from your budgeted rates.
- Actual Rate(s) – these are the actual rate(s) (individual or collective) based on actual expenses incurred. This is what you calculate monthly and at year-end.
- Burn Rate – the daily or weekly total expense amount on a specific contract. For example, you may have a project with a budgeted burn rate of $10,000 daily. This is a quick and easy guide to track remaining time or funds based on the remaining days or weeks. The burn rate may also be known as the planned spend rate.
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.
Total 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.