Indirect Rates - The Basics | Federal Pricing Group

Indirect Rates and the impacts they have on price competitiveness and profitability

We are kicking off a multi-post series to help business leaders and owners understand the relationships between indirect rates, price competitiveness and profitability. Business leaders who understand how various corporate decisions impact their company’s indirect rates can foster more competitive pricing when pursuing federal contracts. For this to occur, managers must know what goes into indirect rates, how they’re calculated, and when they can be adjusted. Additionally, managers should gain an understanding of how indirect rates relate to different contract types. This series will start with explaining the fundamental purpose and calculation of indirect rates. Then, we’ll review the indirect rates common to government contractors, such as Fringe, Overhead and G&A, and dive into the composition and major cost drivers of each one. We’ll explain the differences between, Provisional Billing Rates, Forward Pricing Rates and Impact Rates and discuss why those differences matter in proposal pricing.   Finally, we’ll provide insights into levers, dials and trade-offs business leaders should consider when forming a pricing strategy involving indirect rates and example how difference strategies impact company profitability.

What are Indirect rates and why do we use them?

Indirect rates are used to allocate the pro rata share of indirect costs to contracts that benefit from that indirect cost. This is to ensure each contract shares in its fair portion of the indirect burden. It is also an important tool companies use to recoup management, administrative and overhead expenses from their government customers. For the purposes of this discussion, contract, and final cost objective, are used interchangeably. This post will review the components of indirect rates and illustrate how they are calculated.

What are the differences between direct and indirect costs?

The first step in understanding indirect rates is knowing the difference between direct and indirect cost. FAR 2.101 states: “Direct cost means any cost that is identified specifically with a particular final cost objective.” In this context, a cost objective can be thought of as a contract. Costs identified specifically with a contract are direct costs of that contract. Likewise, all costs identified specifically with other contracts are direct costs of those contracts.

For government contractors, direct costs usually mean the labor, material, subcontracting, inventory and travel expenses that are expended in an effort of to achieve the scope and meet the requirements of a specific contract. A good rule of thumb is the “but for” rule. “But for this contract, I would not incur this cost”. When this statement pertains to a specific cost, chances are it’s a direct cost.

Conversely, indirect costs are costs that benefit two or more contracts. “Indirect cost”, as defined by FAR 2.101, “means any cost not directly identified with a single final cost objective but identified with two or more final cost objectives”. Indirect Costs are those cost that provide support and/or management of a project but not directly charged to the program. A good example of this could be IT Support. As the IT team installs, repairs and maintains computer systems throughout the company, they are helping more than one contract simultaneously. The important thing to remember is; the primary reason companies choose to designate a cost as “indirect” is because it benefits two or more contracts concurrently as it’s being incurred.  For most federal contractors, typical indirect costs include Executive, HR and Financial salaries, facilities costs, employee benefits, paid time off and employee health insurance.

What goes into an indirect rate and how is it calculated?

As shown in the equation below, an indirect rate is obtained by dividing an indirect cost pool by the appropriate allocation base. The numerator of the equation, Indirect Cost Pools, are costs grouped together based on their similar beneficial or causal relationship to a particular cost objective. For example, Fringe Benefits are pooled based on their beneficial relationship to labor costs. Engineering overhead costs are grouped together based on their beneficial relationship to the Engineering function1.  As a rule, companies should have enough indirect cost pools so that each are grouped logically based on the reasons they are being incurred. When determining which indirect costs belongs in which pool, the key question is, “What portion of the company benefits from this expense?”

Indirect Rate % =   Indirect Cost Pool/ Allocation Base

The denominator of the equation, the ‘Allocation Base’, represents a measure of business activity or the cost that benefit or drive the indirect cost pool. Typical examples of an allocation base include, direct labor dollars, direct material costs, or direct labor hours. The key here is a base should be directly related or causes the indirect cost to be incurred. Indirect Costs Pools and Allocation Bases commonly used among government contractors are listed in the table below.  

    1An examination of Total Cost Input vs Value Added Allocation Bases will be reviewed in an upcoming post.

To demonstrate how cost allocation works, let’s use a fiscal year-end actual Divisional Overhead Costs as an example. To determine the overhead rate, the Total Divisional Overhead Pool is divided by Total Divisional Direct Labor which is used as the Base. The result is a Divisional Overhead rate of 10%.

Total Divisional Overhead Costs (Pool): $500

Total Divisional Direct Labor (Base): $5,000

Divisional Overhead Rate = 10%

The Divisional Overhead Rate is then applied to each contract within the Division in order to allocate its pro rata share of Overhead Burden.

As direct labor cost is being incurred by each of the Division’ s four on-going contracts, each receives its share of the overhead costs. So, the total cost of Contract A is $1,650 representing $1,500 of direct labor cost and $150 of allocated Overhead costs. Also notice that Contract C had the highest allocation of Overhead cost because Contract C had the largest amount of direct labor cost.

Suppose we want to know how much to Charge the customer on Contract B next year based on this year’s cost? Assuming next year looks a lot like this year, we should ensure the price of Contract B is at least $935 so that we recoup our direct costs of $850 and $85 worth of Overhead costs.

It’s important to keep in mind that Government contracts pricing is about projecting what will occur in the future. We rely on projected indirect rates that are based on direct and indirect cost estimates. Like all cost estimates, actual cost may, and probability will, vary. It’s vital to monitor indirect rates based on actual costs and compare them to indirect rates base on forecasts for the same period. Why is this important? Because fluctuations to a company’s indirect rates can significantly impact cashflow and profitability. In upcoming posts, we’ll examine how changes to indirect costs over time have different consequences to a company’s bottom-line depending on contract type (i.e. T&M, FFP or Cost-Plus). Additionally, we’ll discuss the composition of indirect rates common to government contractors, the major cost drivers of each and how managers can use that knowledge to position their company to be price competitive.