Indirect Rate Development

Developing Rates for Government Contracts, Part 1

I have been working in the complicated government contracting world for over two decades as a small business owner. In that time, I have been asked many times by other companies, most of the time new starts ups but sometimes established companies much larger, how to develop indirect rates for Cost Plus Fixed Fee (CPFF) contracts. Hopefully this post will give you some idea of how to start the process. I’ll start with reviewing the different types of contracts in this post and then next time we will address budgets and developing your indirect rates.

There are essentially three different types of funding for contracts.

Firm Fixed Price (FFP) — a set price for doing the work regardless of the actual costs incurred. For example, “We will deliver 10 sandwiches for $100.” If it ends up costing us more than $100 to make the sandwiches we still can only bill for $100. If it costs us less than anticipated, we will make a larger profit.

Firm Fixed Price Contracts should be clearly defined tasks as there is no flexibility in the cost structure.

Proposed Actual Cost Bill to

Customer

Profit/Loss
Example 1 $100 $115 $100 ($15.00)
Example 2 $100 $80 $100 $20.00

Examples of Firm Fixed Price Billing

Time and Materials (T&M) — a price based on a Fixed Hourly Rate plus the Actual Cost of Materials. For example, “We will deliver 10 sandwiches. We will bill for $80 worth of materials and it will take us 5 hours at $50/hour.” If we get the materials for less money than anticipated then we bill at the lower cost. However, the labor is a set price per hour even if it costs us more than we proposed. The actual number of hours expended can be charged, however.

Proposed Actual Cost Bill to

Customer

Profit/Loss
Materials $100 $80 $80 $0.00
Labor $250 $300 $250 ($50.00)

Examples of Time & Materials Billing

Cost Plus Fixed Fee (CPFF) — a price based on the actual cost of doing the project plus a fixed fee. For example, “We will deliver 10 sandwiches and will charge you the cost of materials plus the cost of the labor to make them plus a fixed fee (profit).” If the labor and/or materials are less than we proposed, we charge the government less than proposed. If it is more than we proposed, we technically can charge the government more than we proposed.

Keep in mind that the government will only budget as much as you proposed and thus your chances of being reimbursed for any additional costs are minimal as your customer will not have the funds available.

Proposed Actual Cost Bill to

Customer

Profit/Loss
Materials $100 $80 $80 $0.00
Labor $250 $300 $300 $0.00
Fixed Fee 4% $14 $14 $14.00

Example of Cost Plus Fixed Fee Billing

You can see that a CPFF is the most complicated type of contract as you have to closely monitor your costs to stay within budget. Many government contractors go for years without ever having a CPFF contract but eventually the time comes and then they are scrambling to bring their accounting practices up to speed.

It doesn’t sound all that complicated – calculate what it cost you to do the contract and then charge that to the government. The complexity comes in calculating what makes up your costs. There are three basic parts to the “cost”. They are Direct Labor (the salary paid to the employee), Indirect Costs (the costs of doing business), and Fee (also known as profit).

Indirect costs are typically the most difficult to quantify. Although every contractor can divide the pools differently, they are typically broken down into three categories:  Fringe (health care, retirement contributions, vacation, sick, etc), Overhead (computers, rent for space used for billable employees, salary paid to an employee between two billable projects, etc) and General & Adminstrative (accountants, lawyers, rent for space used for administrative functions, etc.).

What makes calculating your costs even more complicated is that the resulting rate you charge on direct labor is a percentage of the Indirect Costs divided by the Direct Labor.

So if your Direct Labor is less than you anticipated then the costs in the Indirect Pool have to be correspondingly less to meet your projected % Rate. Or if your Direct Labor is higher than anticipated, your Indirect Pool costs must also be increased or you will be paying funds back to the government at the end of your fiscal year. To prevent that tragedy, you MUST track both your Direct and Indirect Costs unfailingly so you can make adjustments as needed to your spending.

Be sure to check back here for part 2, where we will review the Indirect Cost Pools a bit more, how to create a budget, what provisional rates are and ultimately what you can charge the government for all your hard work!

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