Introduction

An accounting system that is compliant with the Defense Contract Audit Agency and with Federal Acquisition Regulation 53.209 segregates and accumulates both direct and indirect costs by contract.

Indirect costs are required to be accumulated in common “pools” and then allocated to the contracts using a logical base of costs. This article is meant to be a primer on establishing an indirect rate structure for your organization.

Definition

A company’s indirect rate is expressed as a percentage of an indirect rate base. This percentage is used to allocate the indirect expenses to the contracts receiving their benefit. The indirect rates must consistently and equitably allocate the indirect costs to the contracts.

“Equitably” means that there is a causal/beneficial relationship between the costs incurred and the contracts the costs are allocated to. For example, fringe benefit costs are applied to contract direct labor because there is a causal relationship between the direct labor compensation and fringe benefit being incurred.

Pools and Bases

Indirect rates are calculated by dividing a pool by a base. Each pool accumulates groups of similar expenses while each base accumulates the expenses receiving the benefit of the pool. For service companies, direct labor is the most common base utilized while manufacturing companies may utilize some measure of direct costs incurred or units of production.

Common Indirect Rates

Fringe: A pool of company paid employee benefits over and above base compensation, including expenses such employer paid payroll taxes, paid time off and health insurance. The fringe base would consist of all labor costs, except fringe benefit labor. Contractors may have multiple fringe benefit rates because of the differences in benefit costs among lines of business. For example, Service Contract Act employees may have separate fringe benefit rate.

Overhead: A pool that accumulates indirect costs specific to the performance of the contracts though they are not directly billable to the contract. Examples include operations management labor and the facility rent incurred to house direct charge employees. The most common overhead bases are direct labor and direct labor with a fringe benefit allocation.

“Overhead rates vary greatly because of the different cost structures required to support different lines of business.”

It is common for companies to have multiple overhead rates when they engage in different types of businesses or are performing work at government provided facilities.

For example, two overhead rates, one for professional services contracts performed at the customer site and one for light manufacturing contracts performed at the contractor site. Two overhead rates are used in this example because it is not equitable to allocate indirect costs incurred at manufacturing site to professional employees working at a customer’s facility.

The use of a combined overhead and fringe rate is allowable. Overhead rates vary greatly because of the different cost structures required to support different lines of business.

General & Administrative (G&A): A pool that accumulates management, financial, and other expenses incurred for the general management of the company. Executive management, business development, the accounting and HR departments are examples of G&A. The base is usually total costs of the company excluding the G&A costs. It is highly recommended that only one G&A rate is used.

Handling: Used when a G&A rate is not an equitable means of allocating costs. For example, a contract with high subcontractor expenses would be unfairly burdened with G&A versus those contracts that do not have subcontractors. A handling rate segregates the G&A costs that would be more specific to the direct cost being incurred (i.e. subcontractor, materials).

Assigning Indirect Costs to Pools

This process is subjective with very little guidance provided by the FAR. The key for the contractor is to establish a logical basis for assigning costs and to remain consistent in this assignment from year to year. In today’s environment, many companies are attempting to reduce their indirect rates by direct costing expenses that otherwise would be classified as indirect.

Summary

The above discussion provides a general understanding of indirect rates. The indirect rates of contractors working in the same industry may vary greatly depending on the pools and bases utilized. When first establishing its indirect rate structure, or when contemplating changing the existing structure, a contractor should consider getting advise from outside advisors.

Wayne Clark, CPA is a Senior Manager with Federal Strategies Group, LLC. He provides government contract and management consulting, M&A advisory, forensic accounting and expert testimony to the government contracting industry. He can be reached via email at WayneC@FedStrat.com.