Column: Indirect Rates - Common Questions and Answers

One of the areas in which I frequently receive questions from small business contractors is in the area of indirect costs. Failure to understand the intricacies of your company’s indirect rate can have a tremendous impact on contract profitability and overall company profitability, as well as its cash flows. This article will delve into some of these questions.

Why are indirect rates important to my government contracting business?

The objective of the Federal Acquisition Regulation (FAR), as it pertains to accounting for government contracts, is for the contractor to account for costs incurred on a contract-by-contract basis. This includes both direct costs incurred (costs that are specifically identifiable to a contract) and indirect costs (costs not specifically identifiable to a contract, but benefit multiple contracts).

In order to achieve both contract and overall company profitability, it is imperative that the pricing of contracts includes recovery of both the direct costs of performance as well as an allocation of indirect expenses.

Without establishing a logical and systematic indirect rate methodology, the company may not be pricing its contracts properly. In addition, if indirect rates are underpriced for a contract, negative cash flows can result. Remember, it is not lack of profitability that sinks most small businesses, it is lack of adequate cash flow. Understanding one’s indirect rates can significantly improve your chances of avoiding this land mine.

Aside from the FAR requirements, it is just good financial management to understand the profitability of the company (or lack thereof) and which contract/s are contributing to it.

We have never established an indirect rate methodology, how should we begin this process?

The first step is to break down the expenses in your chart of accounts into direct costs and indirect costs. Direct costs should be broken down into various categories of direct expenses such as direct labor, subcontractors, materials, consultants, and travel, etc.

Indirect costs should then be categorized into logical groupings or “pools.” The most common pools contractors utilize are as follows:

• Fringe expenses – costs related to employees over and above their compensation. Examples include vacation/sick/holiday time, health insurance, 401(k), payroll taxes and educational reimbursement.
• Overhead expenses – costs related to the performance of contractual effort, but are not directly billable to a contract. Examples include rent and utilities for facilities supporting contracts, program/project management, computers and other technologies.
• G&A expenses – costs related to the overall running of the business. Examples include the functions of accounting, business development, human resources, contract and subcontract management, as well as legal and other professional costs.
• Unallowable expenses – costs incurred pursuant to FAR 31.205 that should be segregated from all other costs and not included in any government contract pricing or cost recovery. Examples include advertising, interest, certain types of legal costs, among many others (see FAR 31.205 for a listing of such expenses).

Once you have segregated costs into these groupings, you must now determine a base for allocating these costs to contracts. The most common bases for allocating these costs are:

• Fringe expenses – all labor costs (not including fringe labor, such as vacation, sick and holiday time).
• Overhead – direct labor.
• G&A – total costs (excluding G&A costs).

Finally, contractors will then compute indirect rates (either within the accounting system or outside it via Excel spreadsheets) and will monitor these rates on a monthly and year-to-date basis. Variances between bid and actual indirect rates should be analyzed and understood.

I am receiving some feedback from our client that our rates are too high. What can we do to lower our rates?

Many companies believe that there is some sort of magic accounting wand that can be waved over the indirect rates to magically reduce them. This is just not the case. The two best recommendations I can give to lower its indirect rates is to either; (1) reduce indirect costs, or (2) increase the base for allocating the indirect costs (i.e. grow the company). In absence of achieving these, some common means of reducing one’s indirect rates for a specific contract or group of contracts includes:

1. Establishing multiple fringe rates – useful where differing benefits are provided to differing groups of employees (i.e. those performing under Service Contract Act contracts).
2. Establishing multiple overhead rates – useful when the government is providing facilities to perform for contractual effort.
3. Establishing a material/subcontractor handling rate – this is especially effective for contracts that include large costs associated with direct materials or subcontractors.
4. Establishing service centers – grouping costs into common pools and allocating them based on actual usage as opposed to a general allocation.

Conclusion

The establishment of an indirect rate structure and the subsequent management of one’s indirect rates is an important financial management function for any company that wants to be profitable. Failure to do so can result in lost contract opportunities, lack of profitability, and negative cash flows, all of which can have a detrimental effect on your business.

Michael Smigocki, CPA, CVA is the Senior Managing Director of Federal Strategies Group LLC. Visit www.fedstrat.com/.

SBA releases Procurement Scorecard

Small biz vendor pool shrinking

IG audits AK Native contracts

House OKs 5 small biz bills

Column: Indirect Rates - Common Questions and Answers

Washington Insider: