During the pre- and post-award stages of contracting, you must consider the impact of indirect rate ceilings.
Under flexibly priced U.S. government contracts, your cost proposals include estimates for labor hours and material as well as the application of indirect rates to estimate indirect costs. As a result, the federal government anticipates a certain level of direct labor and material costs and is willing to bear a fair share of your indirect costs. Prescribed clauses provide for reimbursement of allowable direct and indirect costs up to a defined amount.
If your indirect rates and costs substantially exceed the proposals, the government will pay substantially more than the anticipated indirect costs and will receive substantially less than the anticipated direct effort.
This is because there would not be as much funding for acquiring the direct labor and materials as expected when the contract was awarded. It is not, therefore, unusual for the federal government to require or negotiate ceilings on indirect rates.
When Rate Ceilings May Apply
Indirect rate ceilings can arise in a number of different circumstances, including when:
- The Request for Proposal (RFP) states that the contract will include indirect ceiling rates;
- Cost realism during the proposal evaluation concludes that your proposed rates appear to be lower than your anticipated actual rates and ceilings are needed to protect the government from paying significant indirect cost overruns; or
- Legislation and/or regulations are implemented that establish indirect rate ceilings.
You should consider the potential impact of indirect rate ceilings during the pre-proposal stage. Your indirect rates are based on projections of anticipated business base and associated indirect costs. Before agreeing to any indirect rate ceilings, evaluate the potential adverse cost impact if you cannot achieve your business base expectations.
In addition, indirect costs include variable, semi-variable, discretionary fixed, and non-discretionary fixed costs. Some costs can be quickly eliminated when business base fails to materialize or declines. Others take more time to reduce.
Be Quick and Nimble
Preparation and analysis of flexible budgets taking into account various scenarios are crucial to understanding your risks and vulnerabilities, as well as your ability to be nimble if your predictions are off. This will help you determine if an indirect rate ceiling is acceptable and, if it is, the minimum rate you can accept.
During contract performance, you should regularly compare your actual indirect rates to ceiling rates. This will help identify potentially unfavorable variances quickly and take mitigating actions such as:
- Cost reductions through increased efficiencies; streamlining, or other management actions; and
- Other actions, depending on the language in the contract, when cost reductions are not feasible or practical.
Before entering into the contract, it is important to read the language covering the indirect rate ceilings. The language can significantly differ among contracts. The following are two examples:
- General Language:
“The contractor shall not be reimbursed for any indirect costs that result from rates computed in excess of the following:
Overhead Rate 72%
G&A Rate 8%”
- Detailed Language:
“The contractor shall not be reimbursed for any indirect costs that result from rates computed in excess of the rates shown below. These rates are based on the contractors established accounting practices as of the date of contract award. If the contractor makes any changes to these accounting practices, the ceiling rates shall be recomputed based on the revised accounting practices:
Overhead Rate 72%
G&A Rate 8%”
For contracts covered by the Cost Accounting Standards (CAS), the difference in the language between these two examples is minimal because CAS provides for a price adjustment if contractors change accounting practices during contract performance.
However, for contracts not covered by CAS the general language example provides the contractor more flexibility than the detailed language. Under the general language example, the contractor can potentially mitigate the impact of indirect cost rate overruns during contract performance by revising established accounting practices to charge more direct costs and less indirect costs. This reduces the pool and increases the base, which lowers the rate.
In some circumstances, the contractor could also consider changes to the existing cost accounting structure such as reclassifying cost elements between indirect cost pools (e.g. from overhead to G&A), or establish new indirect cost pools (e.g., a new material handling rate). Depending on the circumstances, these actions could also reduce the actual indirect rates.
Note: Whenever restructuring actions of this nature are taken, the resulting indirect cost pools/bases must continue to meet the requirements of FAR 31.203. The actions must apply prospectively not retroactively and usually will have to apply to an entire accounting period. The resulting restructuring must be used consistently for all work and will affect cost distribution for all contracts.
It is important to address the issue of indirect rate ceilings during both the pre-award and post-award stages of the contract.
- During the pre-award process, compute the estimated cost impact of the proposed/RFP mandated indirect rate ceiling and use this data to determine if and/or what ceiling rates you believe you can accept.
- Prepare flexible budgets for various scenarios regarding your business base and indirect cost forecasts.
- Continuously monitor actual indirect rates during contract performance to identify potential overruns as early as possible.
- Mitigate potential or actual overruns through efficiencies, cost streamlining, or other management actions.
- Consider cost restructuring to present lower rates.