Understanding Indirect Rates:
Contract Pricing

Part 2 of 3

By Robert C. Smith, CEO of ICAT Systems

Indirect rates can be one of the more confusing concepts for government contractors to grasp. There are nuances with respect to how indirect rates are used in pricing, cost accounting, and billing. When understood comprehensively, government contractors are equipped to better manage contracts and the business as a whole. I'll explain the role of indirect rates in each of these areas in this three part series.

Factoring Indirect Rates into Contract Pricing

Contract pricing is all about recovering costs and generating fee. Contracts must be priced so that funding is provided to recover the direct costs of performing the contract, recover the indirect costs to be allocated to the contract, and if all goes according to plan, make a profit.

Indirect rates, with respect to pricing, are metrics used to estimate the indirect costs that will be allocated to the contract during the period of performance. The indirect rates are applied to proposed costs so that contract pricing will be sufficient to recover the proposed contract’s share of the contractor’s indirect cost burden.

Historical Indirect Rates vs. Prospective Indirect Rates

It is important to note the distinction between historical indirect rates and prospective indirect rates.

Historical Indirect Rates:

• Measure activity that has already occurred
• Calculated based on accounting data that has been recorded in the contractor’s books

Prospective Indirect Rates:

• Estimate future activity
• Calculated based on budgeting future business projections

It is prospective indirect rates, rather than historical indirect rates, that should be used for contract pricing.

With a detailed budget, a contractor is better equipped to calculate prospective indirect rates for contract pricing purposes. What's more, because prospective indirect rates are used in contract pricing, unanticipated events can easily occur and have a significant effect on a contractor’s indirect rates and bottom line. To mitigate against this, a contractor must maintain a well-managed budgeting function.

Budgeting Prospective Rates

A contractor's budget provides a financial blueprint for future periods. In developing a budget, management will make reasonable assumptions regarding volume of business, staffing, direct costs other than personnel, and indirect costs other than personnel. The budget provides a basis for determining prospective indirect rates and the indirect cost burden associated with a contract during the future period of performance.

When pricing new work, it is important to understand that adding new work can place downward pressure on indirect rates. A well-managed budgeting function enables a contractor to quantify that downward pressure on prospective indirect rates. With this knowledge the contractor can make strategic decisions on pricing new opportunities.

Should circumstances change at some point in the new year, a strong budget equips contractors with a tool for quantifying changes to anticipated costs and indirect rates.