Understanding Indirect Rates:
Cost Accounting

Part 1 of 3

By Robert 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 cost accounting, pricing, 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.

Generating Indirect Rates in Cost Accounting

It is best to begin with the basic accounting concept of indirect rates. From the accountant’s perspective an indirect rate is the ratio of the total costs contained in an indirect cost pool as it relates to its allocation base.

The purpose of the indirect rate is to equitably allocate the costs in an indirect cost pool amongst all contracts benefitting from that indirect cost pool. Each contract shares fairly in the burden of those costs contained in the indirect cost pool.

A common example is the allocation of overhead costs to contracts using direct labor as the allocation base. Overhead costs are those indirect costs which support a particular business segment. For services oriented contractors with a direct labor function, overhead costs support the performance of contract work. It is common to allocate the pool of overhead costs to contracts using direct labor as the allocation base. Consequently, each contract absorbs a portion of the total overhead based on its proportionate share of direct labor in relation to total direct labor.

Expressed mathematically, the total overhead pool is divided by total direct labor to determine the overhead rate. That overhead rate is then applied to direct labor on each contract to determine the share of total overhead absorbed by each contract.

From a cost accounting perspective, indirect rates are calculated for the purpose of allocating indirect costs amongst contracts.