Federal Government Contractor Guidance
Calculating an Indirect Cost Rate
Direct costs are materials, labor, and other costs incurred for a contract.
Indirect costs are those costs incurred that are not directly identifiable to a single contract or customer.
The purpose of an indirect cost rate is to allocate allowable indirect cost to contracts or customers in a fair and equitable manner. In more complicated situations (large businesses), some indirect costs are collected in intermediate pools and then allocated further to the final indirect pools.
The indirect cost rate is simply an arithmetic calculation of dividing a pool of expenses (numerator) by an allocation base (denominator) such as direct labor cost or total direct costs plus overhead. The allocation base utilized for distributing indirect expenses is the method that allocates costs most equitably to the primary cost objective. The allocation base selected could be other than a monetary cost such as square feet, labor hours, or machine hours. The pool should represent indirect costs accumulated by logical groups and distributed on the basis of benefits accruing to the several cost objectives. This means that the existence of the base and the employment of the base activities creates the pool of expenses over a period of time. The pool will consist of fixed and variable expenses.
For example, an overhead center will accumulate a pool of expenses that are related to the work activity of the direct labor employees. Direct labor employees will require support costs such as supervisory salaries (foremen), other indirect salaries (admin), shop supplies, utilities, training, payroll taxes, insurance, lease/rent/depreciation of production equipment and buildings, and maintenance of manufacturing building space.
Depending on the complexity of the company or the industry, examples of overhead cost rates might include:
- Material overhead
- Manufacturing overhead
- Payroll fringe overhead
- Engineering overhead
- Site overhead
The overhead rate allocation base most commonly used is direct labor dollars.
Another common indirect rate is General and Administrative (G&A). The G&A pool consists of expenses related to the overall running of the company. Common G&A expenses are executive and sales salaries, accounting, finance, and HR staff costs, related fringe costs of G&A staff, and utility and maintenance of G&A building space. Utilizing the services of Kline & Co. would also be a G&A expense.
The G&A rate allocation base most commonly used is Total Cost Input (all direct cost plus overhead). Other G&A allocation bases are Value Added and Single Element.
Once the allocation base has been selected, all allowable and unallowable base expenses must be included in the rate calculation to ensure that these items bear their fair share of pool expenses as provided by the Federal Acquisition Regulation (FAR). All indirect cost pools must have unallowable expenses removed from the "claimed pool".
The complexity of the indirect rate structure (number and types of indirect rates) is related to the size and complexity of the business. Thus, the number of indirect rates should be governed by practical considerations.
Kline & Company is ready to assist you in setting up an indirect cost rate structure to achieve the maximum cost recovery of allowable indirect costs and remain compliant with the requirements of the FAR.
This article was authored by Mac Young of Kline & Company for the purpose of providing guidance to our existing and potential clients.
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