Capped Indirect Rates - Friend or Foe?

The answer to this question depends on your perspective as either a government acquisition/grant professional or a government contractor or grantee. Negotiating or directing capped indirect rates on cost reimbursable contracts and in the grant environment may at first appear to be an effective risk mitigation tool for buyers and grant managers. On the other hand, a case can be made that the use of this technique may not necessarily produce the intended results. To be sure, there are plenty of opportunities to reduce a buyer’s risk without resorting to what could be considered “piling on.”


Indirect Rates – A Quick Look

Most readers should be familiar with the Federal Acquisition Regulations (FAR) Part 31 that outlines the framework for measuring direct or project costs, indirect costs, and defining rules for allocating allowable indirect costs to any particular project. The magic of FAR Part 31 is its flexibility to allow any company to design an indirect rate structure and indirect rates specifically for their pricing and operational needs. The results are, or should be, indirect rates that act as a financial fingerprint of the firm.

In its simplest form, an indirect rate is all allowable indirect costs, or administrative costs, divided by project costs. Project costs could include only labor, labor and its portion of fringe costs, or all project costs. Even in this simple example a government contractor faces a handful of choices to calculate an indirect rate.

Indirect rates, if properly understood and managed, can be the financial engine that drives the company from both a pricing and operational perspective. For small businesses, choosing indirect rates that balance costs in a particular competitive environment with enough spending to enable growth takes skilled effort.  Bid at prices where indirect rates are too low, you may go out of business if costs exceed revenue. Bid too high, you could lose work to your competitors.


Capped Rates – Look Out Above

Add to that financial dynamic the threat of “default” rates and “capped” rates. Unless limitations are written into legislation and appropriation bills, government programs usually don’t come with a statutory limit on indirect rates. Some agencies, particularly grant agencies, use either a soft cap on indirect rates or a hard cap, usually with no basis from a regulatory standpoint.

Whether the establishment of capped rates are by custom, designed from some benchmark, or purely arbitrary, sellers in this environment should tread warily.


Hard versus Soft Caps

A hard cap on indirect rates suggests that you as a bidder can estimate no more than a certain percentage of an indirect rate based on some basis, such as total wages. This approach imposes an indirect rate that potentially limits a contractor’s recovery of otherwise allowable indirect costs.

In particular, for a small research and development (R&D) firm, a hard cap makes it difficult to purchase lab equipment, specialty software, or have a robust bid and proposal or business development budget – spending that’s the lifeblood of small R&D startups.

A soft cap is where a solicitation may state a preferred limit for an indirect rate, but if a bidder exceeds the limit, they must provide mounds of data or evidence of an approved rate from a federal entity. This is designed to tempt newcomers to government acquisition and grants to accept the soft cap (or default rate) to streamline the process of both reviewing (buyer side) and defending (seller side) indirect rates. As with hard caps, the default rates are potentially harmful to a small business’s ability to gain and sustain its success.

In still other cases involving cost type contracts, government buyers, even after examining an indirect rate proposal from a contractor, may insist on capping indirect rates at the negotiated rate. Government negotiators may justify this approach by suggesting the contractor is new and inexperienced with managing indirect rates. They may also suggest the data behind a contractor’s calculations are unreliable or the contractor may have failed an accounting system audit or pre-award survey in the past.


Capped Rates – The Case for Extinction

Here are a few reasons why capping indirect rates should go the way of the dinosaur:

  • With capped rates, there is no incentive for the contractor to manage rates. Savvy contractors will incur costs up to the capped limits.
  • Capped rates tilt the cost risk to the contractor, even if indirect rates increase due to actions of the government, such as funding gaps, shutdowns, or rising material costs. From a financial standpoint, a contract having capped rates is effectively a firm fixed-price contract.
  • Cost and funding limitations and notifications on a cost-type contract already provide the government a risk mitigation device, along with scrutiny placed on contractors by the Defense Contract Audit Agency (DCAA).
  • Most contracting officers won’t increase the contract cost ceiling based on indirect rates alone. Contractors must demonstrate a compelling reason indirect rates go over budget before being reimbursed.
  • Capping rates conditions contractors to increase indirect rates on the next solicitation.
  • Capped rates wreak havoc with a job cost accounting system, frustrating financial reporting.
  • How capped rates affect job costs when contractors change their indirect rate structure in the middle of a contract is difficult to answer.


Mitigating Buyer Risk – How Much is Too Much?

To be sure, contractors and grantees can do more to understand the basics of indirect rate proposal preparation and accounting. Yet the government possesses any number of effective approaches for managing cost and performance risks of their contractors and grantees. Pre-award checklists, pricing scrutiny, and financial reporting are just a few examples that come to mind.

To conclude, default and capped indirect rates are on the whole counterproductive in a competitive contracting and grant environment. Using default, or safe rates, lets everyone push the easy button. In the end, this defers true understanding and mastery of pricing and operational accounting on both sides of the table. Acquisition professionals should steer clear and resist this practice.


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