Indirect Rate Calculations and Allocation Bases: Mastering the Basics of Government Contracting

In government contract accounting, few concepts are as complicated as indirect rate calculations and allocation bases, but their importance can’t be overlooked. These concepts ensure compliance with government contract accounting requirements such as the Federal Acquisition Regulations (FAR), Cost Accounting Standards (CAS), and Defense Contract Audit Agency (DCAA) frameworks.

Besides compliance, an excellent indirect cost rate structure means competitiveness during bidding, accurate cost recovery, and profitability while mitigating audit risk.

What Are Indirect Rates?

Indirect rates are used to allocate a contractor’s indirect costs or those costs that can’t be directly attributed to a contract but are necessary for its execution. They are grouped into three categories:

• Fringe rates allocate costs related to employee benefits, such as sick pay, vacation pay, health insurance, and contributions to employee retirement plans.
• Overhead rates allocate the costs of doing business necessary for the contract’s execution. Items such as rent, utilities, and insurance fall under this category.
• General and administrative (G&A) rates are costs incurred to run and manage the contracts. These include administrative salaries, accounting, and legal fees.

Indirect rates are calculated using an allocation base, also known as a cost pool or cost driver.

Understanding Allocation Bases

An allocation base evenly distributes indirect costs among different cost objectives/contracts. It also ensures that indirect costs are allocated in a manner consistent with their benefits to the contract.

The allocation base selected should exhibit a relationship with the indirect costs it is distributing. For example, if the indirect costs are based on salaries, an appropriate allocation base would be direct labor dollars or hours. Other common pools include:

• Machine hours for costs of machinery maintenance
• Direct material costs when materials contribute to indirect costs
• Floor space for rent and utilities
• Headcount for human resource costs

Indirect Cost Rate Formulation

The selection of an allocation base influences the formulation of the indirect cost rate. Depending on the type of base chosen, the indirect cost rate can either be a percentage or a dollar per unit.

For instance, if the allocation base cost driver is direct labor hours, the indirect cost rate would be calculated as a percentage of the total direct labor costs. If the allocation base is machine hours, the indirect cost rate would be expressed as a dollar amount per machine hour.

Indirect cost rate calculation follows a simple formula: dividing a pool of expenses by an allocation base. However, complexities can arise when a company has multiple contracts and different allocation bases are used for each one.

Volatility of Indirect Rates

When indirect costs form a significant portion of a contract’s total costs or the rate structure is poorly developed, variances between the estimated and actual rates can occur. Fluctuations in indirect costs can also affect indirect rates, leading to unexpected changes in the final rate.

This volatility can have several implications, including under-funding, contract delays, or contract cancellation. Government contractors should have a robust system to monitor and control indirect rates. When significant variances occur regularly, recalibration of the estimated rates becomes necessary.

This can lead to over-running rates where indirect costs are not fully reimbursed or under-running rates where the contractor has overcharged the government. Over-running rates can lead to less profits, while under-running rates result in refund obligations.

Indirect Rate Structures: Single-Tier vs. Multi-Tier

An indirect cost structure is one of the government contract accounting requirements auditors check in the pre-award survey. Contractors can choose between a single-tiered or multi-tiered structure.

Single-tier structures are used mainly by contractors with simpler cost structures and relatively fewer contracts. Multi-tiered structures are best for large federal and defense contractors with a sheer volume of varying contracts.

While spreadsheets may offer flexibility and ease of use when developing single-tier indirect cost rate structures, they also have a high propensity to error. This can result in compliance issues and financial repercussions. For multi-tiered rate structures, spreadsheets and substandard accounting systems are not an option.

The industry’s best practices suggest developing indirect rates using sophisticated accounting and pricing systems. These systems can track indirect costs across various contracts, develop pools and multi-tiered structures, and accurately allocate costs.

Work With Professionals to Ensure Accuracy

The Federal Acquisition Regulation (FAR) doesn’t provide specific guidance regarding indirect rate calculations and allocation. Contractors must find their own methodology and be accurate and consistent.

This makes indirect rate calculations and allocation complex. Contractors should work with professionals with experience and expertise in indirect rate structures. The experienced CPAs at Diener & Associates can help with indirect cost allocation and other government contract accounting requirements.

We can help ensure accuracy and compliance while submitting proposals and during audits and can also maximize cost savings and recovery for contractors, ensuring profitability. Contact Diener & Associates for expert guidance and assistance with government contract accounting.