Government regulation requires costs to be classified as either a direct cost or an indirect cost. As we know, indirect costs, in the aggregate, represent the largest class of expenses incurred on government contracts. Direct costs, by definition, are identifiable with a specific “final cost objective” while indirect costs are associated with common or joint cost objectives.
The primary purpose for the allocation of indirect costs through the use of indirect rates is to provide an accurate determination of the “true” cost (including direct costs and equitably allocated indirect costs) of our products and services. Knowing the actual cost allows us to make better management decisions as to what the prices of these products and services should be so that we can receive the desired level of profit or whether we want to make further investments in them at all.
It is extremely important to identify as many indirect costs as possible that, while they may not be incurred to specifically benefit a specific cost objective, can be identified to a restricted function that is applicable to only a selected portion of your products or services (i.e., contracts) and not all. Two common functions generally thought of as indirect include costs incurred associated with material and major subcontractors. This is evident where some of your products or services require direct materials in their manufacture and others do not and where for various reasons certain parts of a given contract may be performed outside of your organization. Allocation of the costs incurred in support of these activities across all of your contractual efforts would not be realistic and dis-proportionally assign costs to products and services that did not require them.
Material Handling Rate
This rate should be considered if you have significant amounts of direct materials or purchased pass-through costs applicable to a portion of your contractual efforts and not to others. Costs to be included in this indirect expense rate pool and allocated to these direct cost categories would include, but not be limited to: purchasing (i.e., vendor selection, price negotiation, order placement, vendor interface and support), vendor quality control, freight/shipping costs, receiving, receiving inspection, stockroom facility costs, stocking and restocking costs, material movement and handling costs and accounts payable.
If all of your contractual efforts require the same level of purchased materials or purchased pass-through costs the need for a separate material handling rate may not be necessary to equitably assign these costs to your products and services. If not, a material handling rate is essential to strategic costing and price development.
Major Subcontractor Rate
A major subcontractor rate should be considered where for various reasons (i.e., lack of required facilities or internal expertise, scheduling, etc.) you are outsourcing a portion of your contractual efforts. Composed of primarily administrative and/or monitoring costs the indirect expense rate pool allocated to these direct subcontract costs would include, but not be limited to:
- selection of the subcontractor,
- negotiation of the terms,
- conditions and pricing of the effort to be performed by the subcontractor,
- performance and compliance monitoring, contract reporting, and
- accounts payable.
As with material handling costs, if all of your contractual efforts require the same level of subcontract support, the need for a separate major subcontractor rate may not be necessary to equitably assign these costs to your products and services. If not, a subcontractor rate is again essential to strategic costing and price development.
Value-Added General and Administrative Rate
General and administrative expenses are traditionally allocated proportionately over all of your business costs except for those costs classified as G&A.
Whether you establish a material handling indirect rate, a major subcontractor indirect rate or both you will be required to calculate your general and administrative (G&A) rate based on a value-added basis eliminating the allocation of G&A expenses to the direct material and/or subcontractor costs included in the subject individual allocation bases. The utilization of the value-added allocation base for G&A will likely increase your G&A rate but will more equitably allocate the remaining G&A costs to those products and services generating those expenses.
While your initial establishment of a material handling or major subcontract rate may be based on budget estimates, they will need to be supported by actuals going forward. Separate direct and indirect accounts should be established in your general ledger to segregate these costs and applicable policies and procedures covering labor recording created to define their establishment and continued application.
Have a question related to your specific situation? Contact the PBMares Government Contracting Team.