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Indirect Cost Series Part 1 – Think Costs, Not Rates

By Adrian Wigston and Rick Claybrook

Most contractors and not-for-profit agencies face challenges when determining the best approach to structure their indirect costs for U.S. Government awards.  Frequently, we hear organizations ponder ways to make their indirect rate more competitive or expressing fear that their rate is too high.  But did you know that comparing indirect rates from one organization to another is not how governmental agencies are instructed to compare bids for competitiveness?  That’s because of a very simple concept: contracting and agreements officers don’t evaluate indirect rates as a percentage; they evaluate the total dollar amount of the indirect costs proposed.

Let’s take an example from the United States Agency for International Development (USAID) and ADS, USAID’s internal organizational guide designed to establish policies and procedures that guide the agency’s programs and operations.  USAID issued the USAID Best Practices Guide for Indirect Costing as a mandatory reference for ADS.  While not regulatory guidance that not-for-profit agencies must follow, the ADS and its Best Practices Guide offer valuable insight regarding how the agency evaluates indirect costs.

Of all the agency guidance we’ve seen, USAID has published perhaps the most accurate explanation of why indirect costs should usually be compared as costs, rather than rates.  Their Best Practices Guide states,

“It is generally not possible to compare indirect costs between organizations at the rate level, whether they are a for-profit or non-profit firm.  Indirect costs must be compared at the cost level.  An indirect cost rate by itself has very little meaning.

We couldn’t agree more. Why? Let’s look at a few examples:

Organization X

In support of its various missions, X had a handful of supervisory level employees and administrative costs that benefitted multiple projects.  In order to equitably share these overhead costs amongst each award it received, X decided to establish an indirect rate and call it overhead.  X decided that direct labor was the most appropriate allocation base for these indirect costs.  In the upcoming fiscal year, X anticipates $1 million in direct labor costs and $250,000 in overhead costs.  Dividing the pool by the base (overhead costs divided by direct labor) yields an overhead rate of 25%.  For every $1 million expended in direct labor, Organization X would recover $250,000 in overhead costs.

Organization Y

Organization Y also used indirect costing.  Unlike X, Organization Y allocated its indirect costs over a different cost base.  Y’s mission required significant storage and inventory requirements for medical products and devices, and Y’s indirect costs centered around the use of these buildings needed to house the items.  Security guards, building leases, utility expenses, and other personnel costs required for the facilities totaled about $950,000 per year (the pool).  Organization Y decided that materials cost was the most appropriate allocation base. In the upcoming fiscal year, Y anticipates $10 million in direct materials (the base) in the regions supported by the facilities costs.  Dividing the pool by the base yields an overhead rate of 9.5%.  Or stated differently, for every $10 million spent in direct materials, Y recovers $950,000 in indirect costs.

Organization Z

A third organization, Z, doesn’t have an overhead rate but, instead, uses G&A.  Z’s indirect costs are mostly corporate level expenses (around $15 million) that benefit the organization as a whole.  Z allocates G&A rate over total cost input (total costs incurred) vs. a smaller base like labor or materials as we typically see in overhead rates.  In the upcoming year, Organization Z  forecasts a G&A rate of 4.5%.

Which rate is more competitive, 4.5%, 9.5%, or 25%?  It’s not possible to tell.  Depending on the cost breakdown of the contract, 9.5% of direct materials could be more or less than 25% of direct labor. Because G&A is allocated over a broader base, 4.5% of total costs incurred might be higher than either of the other two organizations’ overhead costs.

The difference between total indirect costs incurred and allocation bases used between organizations usually makes the rates incomparable. The real question should always be: What is the total dollar amount of direct and indirect costs being allocated to this award, and how might that compare to the competition?

Do scenarios exist where rates can be compared more directly from one organization to another? Certainly.  As an illustrative example, let’s compare two organizations with overhead rates bidding on a service contract in which labor is the primary output.  If both organizations allocate overhead using total salaries as the allocation base and the competitive nature of the award suggests they will bid similar amounts of total labor, it is likely the organization with the lower overhead rate would be more competitive.

Keep these points in mind as you ponder the best way to structure and allocate your indirect costs.  If you read USAID’s guidance cited above, you will see the Agency’s Agreements Officers and Contracting Officers are instructed to compare total indirect costs submitted by offerors, not the rates. The rate is simply an agreed-upon mechanism for you to recapture the total budgeted indirect costs in a systematic manner based on the structure of your organization.

Keep an eye out in 2019 for additional guidance on indirect costing from Nichols Liu LLP as part of our five-part series on indirect costing for government contractors.

2019-06-05T12:43:46-04:00April 24, 2019|Audits & Cost Accounting|