January 22, 2024
By Paul Calabrese, Principal
Government contracts come in various forms, each with its own set of rules and requirements. Critical to a contractor’s financial health, indirect costs are treated differently in fixed-price contracts compared to cost-reimbursable contracts. While fixed-price contractors may not face the same disclosure and cost build-up demands as their cost-reimbursable counterparts, they often struggle with indirect cost recovery due to limited insight and analysis. The good news? There are some practical steps you can take as a fixed price contractor to enhance your recovery of indirect costs.
Challenges Faced by Fixed Price Contractors
Lack of mechanisms for full indirect cost recovery
Many fixed price government contractors are also small businesses who lack mechanisms for full indirect cost recovery. Typically, their accounting software does not address indirect costs or compute indirect rates. Small, fixed price contractors often operate with less sophisticated accounting systems that don’t allow for computation of multi-tier indirect cost rates, so they calculate indirect rates manually outside the accounting software.
While they do not normally operate under a government contract, large commercial firms like construction, manufacturing, or fabrication companies awarded contracts on a fixed price, lump sum basis also struggle with indirect rates. Their accounting systems often do not address indirect costs or compute indirect rates.
Challenges in determining true historical indirect expenses and rates
Many fixed price contractors do not understand the financial impact that indirect costs have in the proposal and post award stages of contract performance, leading to shortfalls in indirect cost recovery.
Often, fixed price contractors do not have a clearly defined chart of accounts for their expenses.
- Their expense accounts may be set up mixing direct and indirect expenses in the 5000, 6000 and 7000 series with no delineation for tracking unallowable expenses. If direct and indirect expenses in the accounting structure are not clearly aligned, it becomes difficult to compute indirect rates for price proposal projections and to assess the impact of indirect expenses on the bottom line.
- A simplistic method for expense accounts is 5000 direct or cost of sales, 6000 fringe benefits (indirect), 7000 overhead (indirect), 8000 G&A (indirect) and 9000 to track unallowable expenses per FAR Subpart 31.2.
Understanding the impact of indirect costs
For cost-type contracts requiring a contractor to support all indirect costs from the beginning of the fiscal year (as an estimate) and at the end of each fiscal year to be adjusted to actual, the contractor must have a complete understanding of how their indirect costs are contributing to the cost recovery of contracted efforts. Contractors with fixed type contracts are not required to disclose or support their indirect costs and internal rates. Essentially, they are effectively driving blind. They are unaware of missing expenses and do not clearly understand why they are incurring losses or even excessive profit. Contractors that had a defective pricing review or a fixed lump sum contract with a change order accounting clause, will leave them unprepared, lacking a clear understanding of their indirect costs that originally contributed to the overall fixed price. Similarly, contractors with a previous commercial item determination are now required to provide historical cost data to substantiate their indirect costs.
Key Takeaways for fixed-price contractors
Contractors with fixed-price contracts can adopt some practical strategies to ensure they maximize indirect cost recovery.
- Track all labor, including indirect activities, in an electronic timekeeping software. Set up indirect labor accounts for overhead, G&A, B&P, and IR&D.
- Establish a clearly defined, logical cost allocation methodology for the indirect rate structure. Although billable time and expenses are “direct”, there can be unallowable or non-recoverable expenses that are also classified as direct, especially internal projects that will impact the allocation base for overhead or G&A.
- Utilize the DCAA ICE model for consistent and logical indirect rates.
- Consider true-up to actual indirect expenses at least yearly. Your cost accounting period must be aligned with your fiscal year-end. Perpetual 12-month rates that are not aligned with year-end are not acceptable and may disguise expense cycles and cannot be used for flux analysis. To have better insight during the fiscal year, consider true-up of cumulative indirect rates at the 6th and 9th month intervals to understand trends.
- Develop an annual budget for the upcoming fiscal year and create projected indirect rates based on the budget forecast.
- Perform a self-assessment using the SF 1408 checklist or engage an outside firm for assessment. If there are RFPs that provide additional evaluation points for an SF 1408 reviews, do not wait until the RFP period to obtain the review. Most firms are unable to turn it around in a short time frame.
- Invest in government contractor cost accounting software for integrated reporting of indirect costs and rates.
Fixed price contractors can navigate the challenges of indirect cost recovery by developing a detailed indirect cost structure for fringe benefits, overhead, G&A and the segregation of FAR Subpart 31.2 unallowable expenses. Since indirect expenses are only determined during the proposal stage of a fixed price contract and not subject to adjustment of the duration of the contract, contractors can optimize their financial performance and be better prepared for post award reviews, and if required, support actual indirect costs under a change order clause. Investing in specialized accounting software can further streamline the process, providing an integrated solution for managing indirect costs and rates.
GRF has the expertise to assist government contractors with establishing indirect rate structures, yearly budget, and indirect rate forecasts, as well as historical indirect rates. GRF’s government contracting team also assists clients in interfacing with government audits of indirect rates.