The government cannot dictate the number of indirect rates you have or how you apply them but they can cite you for non-compliance in the allocation of your indirect costs. Indirect costs are to be allocated based on a beneficial, causal relationship to the projects, contracts or cost objectives to which they are allocated.
Allocating Expenses Based on Total Cost Input
Most companies start out allocating general and administrative expenses based on what is defined as “total cost input”. That is, they allocate general and administrative expenses equally over all of the costs of the organization excluding general and administrative expenses themselves. The mix of costs incurred (i.e. direct labor, fringe benefits, overhead costs, materials, subcontract costs, direct travel, etc.) should remain constant from one project, contract or cost objective to the next. Every dollar of cost incurred is allocated the same percentage of general and administrative expenses regardless of the nature of the cost incurred and its beneficial, causal relationship to the costs being allocated. When this consistency changes and some projects are heavily labor oriented while others are predominately composed of subcontracted efforts or purchased materials (i.e., software), the allocation of traditional general and administrative expenses becomes non-compliant. There is no beneficial or causal relationship of the amount of expense allocated to the base over which these expenses are being allocated.
Utilization of a “Value-Added” Basis
At this point a more equitable allocation might utilize a “value-added” basis for the allocation of costs generally included in the general and administrative expenses. Costs, or portions of costs included in the general and administrative expenses are segregated out into those costs that support the purchase and handling of materials (i.e., a material handling rate) and those that support the process of identifying, obtaining and monitoring efforts performed by a major subcontractor (i.e., a major subcontractor rate). Those costs not included in the material handling or the major subcontractor rate pools are then allocated over the remaining direct costs and associated fringe and overheads generated by the organization itself.
Using the “value-added” basis will most likely increase your general and administrative rate due to the removal of materials and major subcontractor efforts from the allocation base some of this increase will be offset by the removal of general and administrative expenses associated with, and re-allocated to either material handling or major subcontracting. While this higher general and administrative rate would appear to not be beneficial, it better allocates costs to final cost objectives resulting in several benefits:
- Makes you more competitive on proposals containing a large amount of purchased materials or subcontract effort;
- Provides a more realistic cost of your internal efforts; and
- Eliminates the government’s concern related to excessive pass-through costs on costs not generated by the organization.
Material Handling Rate Comprised of Various Costs
The material handling rate would be composed of costs associated with purchasing, receiving, inspection, stocking, incoming freight costs, storage, accounts payable, etc. A percentage of general management costs may also be included based on an estimate of management’s involvement in the purchasing process. Be creative and thorough and document all of your allocation decisions.
Major Subcontract Rate Differs from Material Handling Rate
The major subcontract rate contains different efforts than those associated with material handling. Generally the decision and execution of a major subcontract is not a purchasing effort. It involves selection of a partner in contract performance, many times by direction. It is more of a contracting function including different contract terms and conditions and compliance flow-downs and performance monitoring than those involved through the normal purchasing process, As with the material handling rate a percentage of general management costs may also be included based on an estimate of management’s involvement. Again, be creative and thorough and document all of your allocation decisions.
Switching to a “value-added” general and administrative rate with complimenting material handling and major subcontract rates will more realistically allocate your indirect costs on a beneficial, causal basis and provide a more realistic picture of the true cost of your products and services. Want to learn about developing a cost allocation plan? Click here to read our blog post discussing this underappreciated and much maligned management tool.