# Indirect Rate Calculations

Published
Jan 31, 2020
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The final segment of Determining Overhead Rates in Government Contracts culminates with how indirect rates are calculated and a walk-through of sample calculations.

## Transcript

James Seary: Indirect rate calculation. An indirect cost rate is a ratio between a pool of costs, which can be fringe, manufacturing, so forth, divided by a defined allocation base. An allocation base is a measure of activity that is used to charge a cost to a final or intermediate cost objective. On the next page, these are some examples of typical cost pools and the base associated with it. So how this slide works…if you look at fringe benefits, you look at a fringe health insurance, pay roll taxes, health, dental, life, so forth, vacation time – that gets accumulated into a fringe pool, all those costs. And an allocation base that makes sense for that is labor because labor produced, that's an offset of your labor cost. So in that case, your cost pool would be the accumulation of those fringe benefits over your total labor. Another example would be a few down - subcontract handling. In that case, your pool would probably be your contract, people that deal with your subcontract, your procurement people that are procuring a subcontracted service. You'd accumulate those costs. And the base would be the total subcontractor costs that you're using - all their invoices and charges that you're applying against contracts. So it has to make sense and there has to be logical sense, which we've talked about before with the relationship between your pool and its base.

Common primary cost pools. Operations overhead - example, manufacturing, engineering and field service, so forth. Typical costs found in cost pool: indirect labor and supervision - your accounting personnel, your human resources, those are indirect labor benefits to the whole company. A perishable tooling is used within a manufacturing overhead process. These are all examples of indirect costs that you'd accumulate at the pool level. Primary cost pool such as material handling. The typical cost found in the cost pool with this is the example I mentioned before. You have your purchasing department, you have your procurement people, all that cost associated with getting your material to your customer that's a logical basis for accumulating those costs. And the allocation base would be the total material purchase. The G&A pool. This is what we talked about. This is your executives of the company, your legal, accounting, public relations department. These costs are costs that are at the benefit of the whole organization. So these costs that you accumulate for this cost pool are often allocated over the whole remaining costs of the whole company. So that'd be both your direct charges and your other indirect pools.

Anthony Faugno: What we're going to do for the next few minutes is we're going to go through some examples with numbers of indirect rate calculations in different types of cost pool structures. What you have on these screens, first here is just the numbers we’re going to use in the calculation. Visualize this as your expenses in your chart of accounts. I just have totals there to fit it on the slide, but visualize that as many accounts within each one of these totals. So we're working with total cost of \$855,000, as you can see.

So now we take our chart of accounts, the 855,000 total and we break this up into pools. There's our direct cost into labor and other direct costs and an overhead pool and a G&A pool. This is a two tier indirect rate structure. So basically our two tiers are our overhead and our G&A. So, the next slide we'll show how we calculate the rates with this type of structure. So we have our overhead pool, that's our costs. And then our base for our overhead rate is going to be direct labor. So you can see, we calculate our overhead rate at 122.62%. G&A pool and our base for G&A pool generally it's a total cost before G&A. It's also known as total cost input. So you can see here our calculation is 7.04% when we divide our G&A costs by our total costs. And your proof is always to prove back to your an 855,000 total. So when you do all your calculations and you apply your rates, you should come back to your total costs.

Next example, this is a three tier rate structure. So we introduce here a fringe benefit pool. The spreadsheet is set up the same, we add the fringe benefit pool, then we allocate the fringe benefits to the other pools. So that's called an intermediate cost pool. We allocate fringe benefits based on labor to the other cost pools. As you can see the fringe benefit pool zeros out, but they're allocated to the other pools. So you can see the totals for each of the pools there. And so if we go to the next slide, you can see our fringe benefit rate calculation. The fringe benefits are 145,600 and our base for a fringe benefit, our fringe rate is going to be our total labor. So you can see the calculation there comes out to 42.86% in this example.

And then as you continue with this, now one thing you'll notice here is the overhead rate and the G&A rate. G&A rate is the same I believe, but the overhead rate has gone down significantly from the example with the two tier. The reason is because we separated the fringe benefits. Now, sometimes we might want it from a strategic standpoint as a government contractor, to go with a rate structure like this for bid and proposals to be more competitive. It's better to show or could be better to show a lower overhead rate.

We mentioned earlier about a site rate. This is an example where we introduce a site or a field rate. Basically you have two overhead rates. You have a home office overhead rate and a field overhead rate. So it's the same type of calculations. You just have to segregate the costs in the pools that you decide you're going to use. So again, everything ties back to the 855,000 in our example. And if you go onto the calculations of the rates, you'll see that the fringe benefit hasn't changed. But now we introduce the site and field rate and the G&A stays the same. But again, everything totals out to the same \$855,000. So you can present your company in different ways depending on what your business is and what makes sense.

For the sake of time here, there's a couple of examples in the handouts you were given or the power point that everyone I believe was emailed. So you can go through those calculations. But this page here is a summary of the different methods. As you can see when you put them side by side, you can see that you can present your company in different ways and you're still going to come out to your total costs. It's just how it makes sense for you and your business to be presented in proposals and to the government. Once you establish your rate, as James said earlier, you want to be consistent carrying that forward. You can make changes as the company changes, but you have to notify the government and get approvals for changes. So back to what I was saying before, you could take a very simplistic approach or get very complicated and even go beyond a four tier rate structure.
JS: It just comes down to where are you today? Where do you think you're going to be tomorrow? What matters to your end customer? How do they see it? But you don't want to just make it over complicated for the sake of being over complicated. You should try to design this with a business purpose in mind. Just something to consider as you go forward.
AF: This last slide here, this is just a calculation of loaded time and material labor rates using the three tier example in our 855,000 example. This is how you would come up with your billing rates. You're loaded billing rates for your employees. Just in summary, the importance of maintaining an accounting system and tracking indirect rates is to maximize cost recovery, for efficient preparation of proposals and budgets, to support invoicing for government audit readiness and to avoid issues which were out of scope in today's presentation but things such as defective pricing issues or false claims with the government. You don't want to ever get into those situations.

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This video from our series Determining Overhead Rates in Government Contracts breaks down how Proper Cost Pools must be established within a government contractor’s accounting system. This means segregating costs into direct, indirect, and unallowable cost pools.

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Anthony J. Faugno

Anthony Faugno is Partner-in-Charge of the firm’s Federal Government Contracting Group assisting clients in complying with the government accounting regulations related to their federal contracts/grants for closely held and family owned businesses.

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