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In the first of this series of articles on selling to the federal government, I discussed federal takeover regulations (FAR), cost accounting standards (CAS) and types of contracts issued by government agencies.
In the second article, I expanded on the principles of cost accounting and introduced the concepts of direct and indirect costs. In this article, we will discuss indirect rates and price structures in more detail. As a reminder, an indirect cost is a cost that cannot be easily allocated to a single contract or cost target.
When responding to requests for proposals (RFPs), contractors are generally required to forecast the direct costs of contract execution and charge direct costs at their indirect rates. This represents a decision point because the contractor’s indirect historical prices, used to allocate the contracts’ historical costs, may not be the most appropriate rates to use when bidding on the next contract opportunity. Many questions arise, such as:
• How is the current indirect structure of the contractor formed?
• Will the new contract significantly change the contractor’s historical indirect prices?
• Is the contract being submitted for bid very competitive, which requires the contractor to reduce costs and leads to overall reductions in the indirect rates of winning the contract?
For all these reasons, it is important for contractors to understand their indirect rates and determine the best indirect rate structure for their operations as well as future bidding activities.
Choose the best price structure
Indirect rates are calculated to allocate indirect costs to ultimate cost objectives. Each indirect rate is generated as a ratio of the cost pool to the distribution basis. Both the aggregate and the base are important when calculating indirect rates and assigning these cost groups to contracts. An indirect price structure is a pricing system used by government contractors to determine the cost of fully overburdened labor. It is a pricing system that has been in use for decades and has been updated over time to include more considerations and provide additional clarity to contractors.
Indirect price structures include all the indirect rates used by the contractor to allocate the total costs incurred to the final cost objectives. A simple price structure may include a single indirect cost pool and rate, while a more complex price structure can consist of many indirect cost pools and rates, including intermediate cost pools. While indirect rates are used by contractors to determine and report total contract costs, rates are also used to support pricing efforts when contractors are bidding on government contracts.
So how does a contractor determine the best indirect rate structure to implement? Certainly, FAR provides guidelines for calculating indirect rates and how to think about pools and bases. FAR also provides flexibility according to each contractor's business model since every business operates differently.
Given this flexibility, smaller contractors may prefer a simple price structure that is efficient in maintenance and computation and which may include one or up to three pools. Larger contractors may have complex operations that require a more complex, indirect rate structure and the addition of intermediate groups to allocate indirect costs to jobs more efficiently.
An example of an intermediate pool is the utility pool, which aggregates all costs related to facility maintenance and allocates those costs to final cost objectives or to other indirect cost groups, such as the overhead (OH) and general and administrative (G&A) groups.
Some of the process questions that contractors may consider when considering an indirect price structure that may be more appropriate for their business include:
• What are the primary cost drivers of the business? Staff labor, materials, and subcontract costs all have unique effects on indirect labor costs and price structures.
• Are there different categories of labor employed? If so, do these employee categories have different fringe benefit packages? If so, more than one marginal pool may be warranted.
• Are there different types of contracts executed by the company with different cost factors? For example, a contract that requires significant employee labor may have a significantly different cost driver than a contract that requires large materials or computing costs. Where there are material differences in cost drivers, multiple cost groups and rates may be justified to accommodate the allocation of costs to different contract types.
• Does the company have multiple locations and/or a home office that offers shared services? If so, shared home office services may be treated as an intermediate cost pool. In addition, per-site cost structures may need to be considered to determine whether multiple facility pools are warranted rather than a single facility pool that aggregates costs from all facility locations.
• What level of complexity can the contractor's accounting team support? If the contractor has a strong accounting team, complex price structures may not be that expensive. However, when contractors are small, a complex structure can slow the accounting department to a crawl, limiting the availability of timely and accurate information.
• What level of complexity can the contractor's pricing team support? A strong pricing team may be able to create a structure to estimate the impact of the new contract on future indirect rates. In this scenario, updating indirect historical prices when pricing new opportunities makes sense to try to maximize profitability. Otherwise, using a simple indirect rate structure for pricing by applying historical indirect rates and incorporating only minor adjustments for new bid opportunities may be the most realistic path forward.
There are many factors to consider when deciding the best indirect rate structure to implement. The key takeaway is that each contractor must consider their own operations, future bid opportunities and in-house capabilities when determining the best indirect price structure for calculating and allocating historical costs as well as future opportunities. The right structure is one that is maintained without overburdening the accounting team and is the most representative of the contractor's operations and bidding opportunities.
The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice on your specific situation.
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