A Government Contractor’s Guide to the Indirect Cost Rate Life Cycle

"What are my indirect rates?"

The answer depends on where you are in the Federal Contract process — pricing proposals, invoicing on a contract, monitoring indirect rate variances, or determining final indirect rates.

A government contractor and the contractor’s accountant will typically understand indirect rates differently. Why? Their involvement with indirect cost rates occurs at different points in the indirect rate life cycle.

A government contractor applies indirect rates to direct costs to arrive at proposed pricing when developing the cost volume of a proposal. The contractor‘s objective is to establish pricing at a level that will enable the recovery of indirect costs during the period of performance of the proposed contract (and make a profit).

The accountant determines indirect rates that result from costs incurred and posted to the contractor’s books.

The company’s final actual indirect rates are settled at the end of the indirect rate life cycle.

This guide explains the relationship between indirect cost rates at various stages in the government contracting process:

• Estimated indirect rates for pricing
• Provisional rates for billing
• Actual indirect rates based on costs incurred
• Final indirect rates

Estimating Future Indirect Rates

The contractor’s use of indirect rates involves estimating what indirect rates will be in a future period. Estimates of what indirect rates will be in a future period are used for two purposes:

1. To price a contract proposal
2. To estimate indirect rates on the front-end of a year to establish provisional billing rates

Provisional billing rates are estimates of the contractor’s indirect rates that are used to bill indirect costs on cost-reimbursement type contracts, pending determination of the final actual indirect rates once the contractor’s year has ended and the books have been closed.

FAR 42.701 defines provisional billing rates as:

an indirect cost rate
(1) Established temporarily for interim reimbursement of incurred indirect costs; and
(2) Adjusted as necessary pending establishment of final indirect cost rates.

Calculating Actual Indirect Rates

The accountant’s use of indirect rates involves determining what actual indirect rates were during a period that has ended, after the books have been closed.

Upon closing the books at the end of an accounting cycle, the accountant determines indirect rates resulting from actual activity. Indirect costs are allocated to contracts using those actual indirect rates.

The contracts absorb a portion of the contractor’s indirect cost burden that occurred during the accounting period. The accountant then generates contract cost reports that include the indirect costs that have been absorbed by the contract during the respective accounting period.

Comparing Actual vs. Provisional Indirect Rates

Once actual indirect rates for an accounting cycle have been determined, a comparison is made between the actual indirect rates and the provisional indirect rates that were used for billing purposes. This comparison of actual to provisional will result in the contractor’s indirect rate variance.

The indirect rate variance is the difference between the indirect costs billed on a provisional basis and the indirect costs that were actually absorbed by the contract during the contractor’s fiscal year.

The contractor may have billed more than the actual indirect costs, in which case the contractor has over-billed the contract; or the contractor may have billed less than the actual indirect costs, in which case the contractor has under-billed the contract.

Determining Final Indirect Rates

The contractor submits a Final Indirect Cost Rate Proposal (Incurred Cost Proposal) following their fiscal year end to quantify indirect rate variances on cost-reimbursement type contracts. This is the point in the indirect rate life cycle where actual indirect rates are determined based on costs recorded in the contractor’s books of account.

Ultimately the contractor must settle the indirect rate variance with an adjustment voucher pursuant to the rules set forth in FAR 52.216-7(d)(5):

Within 120 days (or longer period if approved in writing by the Contracting Officer) after settlement of the final annual indirect cost rates for all years of a physically complete contract, the Contractor shall submit a completion invoice or voucher to reflect the settled amounts and rates. The completion invoice or voucher shall include settled subcontract amounts and rates. The prime contractor is responsible for settling subcontractor amounts and rates included in the completion invoice or voucher and providing status of subcontractor audits to the contracting officer upon request.

Indirect Cost Rates Over the Life of the Contract

The indirect rate life cycle can be summed up as follows:

1. Estimate Indirect Rates for Pricing — The contractor’s cost proposal utilizes an estimate of what indirect rates will be during the period of performance of the proposed contract.
2. Bill using Provisional Rates — The contractor will propose provisional billing rates on the front-end of each contractor fiscal year (not the contract year) to be used for billing indirect costs on cost-reimbursement type contracts.
3. Determine Final Indirect Rates — The contractor will submit a Final Indirect Cost Rate Proposal (commonly referred to as an Incurred Cost Proposal ) to quantify indirect rate variances on cost-reimbursement type contracts.
4. Settle Indirect Rate Variances — Indirect Rate Variances are settled consistent with the requirements set forth in FAR 42.705(b) and FAR 52.216-7(d)(5). This will require the contractor to submit a completion invoice or voucher reflecting the settled amounts and rates.

How can I make sure my rates are accurate?

To make effective, reliable estimates of what indirect rates will be (steps 1 and 2 in the life cycle), you should have an effective budgeting function in place. A forward-looking planning process helps ensure budgets will be reasonable and can be relied upon during the pricing phase of a cost proposal.

You should also ensure that accounting cycles are closed in a timely manner so that indirect rate variances are quantified and evaluated, and that any corrective action needed is executed. Government contract accounting software like ICAT for QuickBooks® will automatically calcluate indirect rates to give you a clear and timely view of your finances.