Government Contracting 101 - Part 5: How Does The Government Make You Pay Your Fair Share of Your Indirect Costs?

 In a cost reimbursable job, we all know how the government will pay for direct labor and materials.  In these awards, they also pay for a “fair share” of your overhead (or indirect costs).  How does the government determine, and pay for, their “fair share” of your indirect costs?

Let’s start with the basics: when you bid on a contract, you figure out how much it is going to take (cost) to make the program work.  You add all your labor hours, materials, equipment, travel, etc.  These expenses are exclusive to this effort and therefore called “direct expenses”.  These costs can only benefit this one contract or, as the government calls it, a "final cost objective."  There is, however, a lot more that goes into running your business.  You have accounting costs, administration costs, printers, electricity, rent, etc.  These are called indirect costs because they benefit more than one final cost objective.  Where are these costs captured?  More importantly, how does the government determine what their “fair share” of these costs are?

The government determines their fair share by having the contractor calculate Indirect Billing Rates.    From a 30,000-foot level, these are complex calculations, determined by regulation, to allow the government to reimburse the contractor some portion of their overhead expenses.  In our next Blog Topic ‘What is an Indirect Rate?  Why would you have more than 1?’, we will go into the definition of indirect rates and how they are calculated.   This blog, however, is an introduction into the concepts of why we have indirect billing rates.

It is easy to take direct costs that you know you will need to run a program and add them up.  The non-direct or indirect costs can get a little more complicated.  If you have only one program and no other activity, then it would be easy; all your allowable indirect costs would go against your one and only program.  In this scenario, the government would know precisely that they were paying their fair share of your indirect costs because all your indirect costs would be the fair amount (since all efforts of the company support only one job).  But what if you have two, three or ten programs going? What if some of these jobs are commercial in nature?  How does the government determine what is fair from one program to another? 

The only way to do it would be to divide the indirect expenses by a fair, equitable determination of direct expenses in a way that creates a ratio that can be applied back to each program.  This denominator in the ratio is commonly called the “base”.  This process spreads all the indirect costs back into all the programs in a manner that is proportionate to the magnitude of each program, thus providing a fair share of indirect costs for each program.  If this is done correctly, the government can look at any of your programs and determine that the fair share of indirect costs is allocated to each and every program.  This can be a simple one rate structure for a small company (covering all indirect expenses) to a multiple rate system for larger companies, with rates for overhead, G&A, Materials & Subcontracting, On-site, Off-site and other potentially complicating evaluations. 

To follow the logic of the previous paragraph, we have created an example based on a one rate structure, using total direct costs as the basis of calculation and a total company indirect amount of $1,200,000.

  Project 1 Project 2 Project 3 Project 4 Company Total
Total Direct Costs $750,000 $200,000 $150,000 $500,000 $1,600,000
Indirect Applied $562,000 $150,000 $112,500 $375,000 $1,200,000
Indirect Rate 75.00% 75.00% 75.00% 75.00% 75.00%
Total Contract Cost $1,312,500 $350,000 $262,500 $875,000 $2,800,000

Using the example above, you can take any one of the projects and quickly see that project is assigned its fair share of the total company indirect costs.  So if Project 1 was commercial, Project 2 was a Government Agency A contract, Project 3 was a Government Agency B grant, and Project 4 was a Government Agency C contract, each agency would be able to view and verify that they were being assigned only their fair share of your total indirect costs.

Depending on the agency, there can be several checks that are instituted in your rating system.  Some agencies only allow you to rate current year using last year’s rates, some required forecast budgets to establish a provisional rate and then an end of year rate based on actuals to make adjustments.  Regardless of the system, each agency is attempting to ensure that they are paying the correct amount of indirect expenses that is fair to their contract and only their contract.

Of course, this is just a very simple example.  Most companies will have a more complex set of calculations where the base of the indirect rates is governed by many different regulations.  There are even some overhead expenses (and direct expenses) that are what the government deems “unallowable”.  The government will not reimburse for unallowable expenses of any kind (we will discuss unallowable costs in future blogs, and ReliAscent does have white papers on the subject as well---visit our White Papers and Checklists page for more information).

- Brian Ormsby, ReliAscent