Pricing Matters – Indirect Cost Calculations

By Ronald Marta, University of Houston PTAC

One of the most important and distinctive characteristics of pricing for government contracts is the use of indirect cost rates.  FAR 31.203 provides the relevant guidance:

What are indirect costs?
“After direct costs have been determined and charged directly to the contract or other work, indirect costs are those remaining to be allocated to intermediate or two or more final cost objectives.”

How are indirect costs to be treated?
“The contractor shall accumulate indirect costs by logical cost groupings with due consideration of the reasons for incurring such costs.”

How are indirect costs to be allocated?
“The contractor shall determine each grouping so as to permit use of an allocation base that is common to all cost objectives to which the grouping is to be allocated. The base selected shall allocate the grouping on the basis of the benefits accruing to intermediate and final cost objectives.”

What is the base period for allocating indirect costs?
“The base period for allocating indirect costs is the cost accounting period during which such costs are incurred and accumulated for allocation to work performed in that period.”

To summarize the FAR guidance, indirect costs are all costs remaining after direct costs have been determined. Contractors are to put their indirect costs in logical groups, select an appropriate base, and allocate costs for the period of contract performance. The allocation of indirect costs involves the calculation of indirect rates. The allocation is to be accomplished on the basis of benefits received.

Typically, small businesses will require only two indirect rates: a payroll overhead rate and a General and Administrative (G &A) rate. In some cases, they may need only the G & A rate.

A model for the calculation of indirect rates for government contracts follows


Pricing Matters Indirect Costs table

The above indirect cost model elicits the following comments.

  1. The model is intended for illustration purposes only. It does not contain all of the accounts that a particular contractor would need in order to calculate her/his indirect rates.  Click here for a much more comprehensive template.
  2. The base for the payroll overhead rate is productive labor. If there are management/support labor costs in the G & A pool, these costs would be added to the direct labor to obtain the proper base.
  3. The base for the G & A rate is typically total cost input. This means all costs before G & A expenses. Other bases are possible, for example: productive labor, value added, etc. The use of other bases usually depends on the nature of a particular business. For example, if a business is very labor intensive – such as a small business offering security guard services – then a productive labor base might be appropriate.
  4. The model takes its pool and base numbers from the contractor’s actual cost records. Therefore, if the model is applied systematically, there is a guarantee that the contractor will recover all of her/his costs. This should be an important concern for all contractors.
  5. The template allows for cost adjustments as well as escalation. This is important, because the contractor’s indirect rates as they are applied should coincide with the period of contract performance.

Since the calculation of indirect rates is based on the contractor’s actual costs plus any adjustments that may be appropriate, the contractor does not need to wait until s/he is preparing a bid for a government contract to calculate indirect rates. Indeed, the contractor should not wait. When the contractor is preparing a bid, there are many things to do in a limited time; in some cases a very limited time. If the indirect rates have already been calculated, the preparation of the bid is that much easier. Moreover, indirect costs and the associated rates are something the contractor needs to monitor periodically and carefully. There is a direct relationship between indirect cost pools and indirect rates. As the pool costs increase, the rates increase. It will be to the contractor’s advantage to keep the pool costs as low as possible in order to have rates that are as competitive as possible.

There may be trends or averages for indirect rates for particular industries. However, since cost structures typically vary from company to company, comparisons with industry averages may be helpful, but business owners should look first and foremost to the indirect costs and rates for their individual companies. In the final analysis, it is that information that will surely prove to be the most important.

Pricing Matters is a regular feature by Ronald Marta.  Watch for future posts on a wide range of pricing issues.

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Ron Marta Headshot
Ronald S. Marta has been a Senior Procurement Counselor with the University of Houston PTAC since 2008.  Prior to that, he served as an auditor for 15 years with the Defense Contract Audit Agency (DCAA) and 7 years with the NASA Office of Inspector General at Johnson Space Center. His special areas of interest include accounting systems, proposal preparation, cost analysis, and audit preparation.  Ron is a Certified Public Accountant and holds Master’s degrees in Business Administration and in Professional Accounting.

The UH PTAC is a specialty center of the University of Houston Small Business Development Center Network.  UH PTAC provides government procurement consulting and training to 43 counties in Southeast Texas.

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