Strategies for Indirect Rate Optimization

Introduction

In government contracting, thoughtful indirect rate development is critical to helping clients strive to maximize  cost recovery and enhance competitive positioning. Government contractors often design indirect rate structures for compliance with the Federal Acquisition Regulation (FAR) and Cost Accounting Standards (CAS) due to the compliance risk and regulatory oversight associated with indirect rates. While compliance is an inherent aspect of indirect rate design, dedication to optimization goes beyond meeting regulatory requirements. 

Read on to learn more about key concepts, strategies, and practical guidance to help clients work toward optimizing indirect rates.

Understand the Basics 

Common indirect cost pools for government contractors include Fringe, Overhead, and General and Administrative (G&A) expenses. When committed to optimizing indirect rates, contractors must understand the common indirect cost pools that form the foundation of any rate structure:

• Fringe: Fringe costs include employee-related benefits expenses, such as health insurance, paid leave, retirement contributions, and payroll taxes. Fringe pools are designed to capture costs that are part of the overall compensation package and directly tied to employee well-being.

• Overhead: Overhead costs are often associated with supporting the direct execution of two or more contracts. Examples of overhead expenses include facilities, maintenance, IT support, and operational supplies.

• G&A Expenses: G&A expenses are those necessary for running the organization or business unit as a whole, benefiting the entity broadly. They include executive salaries, legal fees, and other corporate-level support.

• Unallowable Costs: Certain costs, such as entertainment expenses, alcoholic beverages, and fines and penalties, must be excluded from indirect cost pools to remain compliant with FAR Part 31, which outlines the principles for determining the allowability of costs under government contracts.

Understanding these pools is fundamental for effectively structuring indirect rates, helping ensure they align with the cost recovery objectives and compliance requirements.

To achieve accurate and equitable distribution of indirect cost pools, contractors need to select an appropriate allocation base. According to FAR 31.203(c), indirect cost groupings must be structured to allow for the use of an allocation base that is common to all cost objectives receiving the allocation. The selected base should reflect the extent of the benefits received by each cost objective, thereby establishing a clear cause-and-effect relationship between the cost incurred and the allocation base used. Further, CAS 418 requires allocation of indirect costs based on a logical and consistent method that best represents the benefits received by each contract. 

Common allocation bases for overhead and G&A expenses are as follows: 

• Overhead: 

  • Direct labor dollars
  • Direct labor dollars  and associated fringe allocation

• G&A: 

  • Total cost input (total direct and indirect costs excluding G&A) 
  • Value added (total cost input less subcontracts and direct materials)

Optimizing Rate Structure

Strategically allocating indirect costs can help contractors focus on maximizing cost recovery on government contracts and provide a competitive advantage. In instances where indirect costs benefit various sectors of the organization differently, allocation may be more complex, and FAR 31.203(f) supports the use of intermediate expense pools or service centers to help ensure equitable cost distribution. In these cases, organizations may explore possibilities of developing more complex indirect rate structures. Common trends include:

• Government- and Contractor-Site Overhead Pools : Organizations often set up a government-site (or customer-site) overhead rate when the costs and allocation base for the overhead cost at government locations are different from the usual contractor facility overhead rate. Typically, government-site overhead rates exclude the organization’s facilities costs. In these cases, the higher contractor-site overhead rate would not accurately reflect the cost relationship with personnel working at government locations.

• Material Handling and Subcontractor Pools: Organizations with projects that include significant material usage or reliance on subcontractors may create a separate indirect pool for material handling and subcontractor administration costs. The pool would include costs related to procurement functions, receiving, storing of material, and subcontractor management. 

• Functional Overhead Pools: Organizations may differentiate overhead by function, such as manufacturing or engineering. Costs associated with supporting manufacturing activities, like equipment maintenance and factory costs, would be separated from those supporting engineering activities, such as research and development or technical support. By differentiating by function, organizations can more precisely allocate costs to the appropriate functions, supporting each department in bearing the costs that are directly related to its operations. 

• Customer Type Overhead Pools: Organizations may differentiate overhead by customer type, such as government versus commercial customers. For example, government contracts require more stringent compliance measures that can affect overhead costs. On the other hand, commercial contracts might have different requirements and cost structures. By differentiating overhead costs based on customer type, organizations can verify that costs allocated to government contracts are compliant with applicable regulations and help maximize recovery of allowable costs, without over-burdening commercial contracts with the additional cost of compliance. Similarly, unallowable costs that cannot be allocated to government contracts may be recovered through commercial pricing.

• Service Centers: Service centers are functional groups that provide support to various parts of the organization to varying degrees and are mostly allocated based on actual consumption. Organizations must consider the significance of the costs and the administrative burden of managing these service centers before adopting this model. Common service centers include IT, HR, and Compliance. For example, if the IT service center provides technical support to multiple departments residing in different indirect pools, the costs of maintaining the IT infrastructure and personnel would be allocated to those departments and pools based on the amount of support each receives.

• Home Office Allocations: The home office refers to the central management and administrative functions that support the entire organization. Organizations with multiple business units or segments can use a home office allocation structure to distribute the costs incurred at the central office across various entities, divisions, departments, or segments. This approach helps each entity, division, department, or segment bear a fair share of the central office expenses, which typically include executive salaries, administrative support, office rent, utilities, and other general expenses necessary for the overall operation of the business. Contractors may use a corporate home office approach or a more complex structure with both a corporate home office and intermediate home offices. 

The Implications of Changing Indirect Rate Structure

Changes to an organization’s indirect rate structure can have significant implications across compliance, operations, and financial performance. Key considerations and impacts include:

• Financial Modeling : Before implementing changes, model financial outcomes under the new structure to assess impacts on margins, pricing, and competitiveness.

• Customer Communication: Organizations must weigh how their customers will react to changes in their rate structure. Transparency and justification are critical to maintaining trust and contract continuity.

• Internal Training: Personnel need to be trained on the new structure to help ensure accurate application and understanding across departments.

• System Integration: Determine the need for accounting system updates to reflect the new rate structure, effectively identify cost pool and allocation of base elements, and/or modify reporting mechanisms.

• Communication With Key Regulatory Stakeholders: If an organization is subject to full CAS coverage, it will likely need to prepare and submit cost impact proposals to its Contracting Officer (CO) and Cognizant Auditors. Even if the organization is not subject to full CAS coverage, it is important to notify key regulatory stakeholders prior to implementing changes to its indirect rate structure.