Indirect cost rates are an important element of every government contract. They provide a ratio between the indirect costs and a direct cost base and, therefore, measure the efficiency of the business. Plus, a business is only profitable when all costs are recovered.
Indirect cost rates are not stationary and should be monitored frequently. Below, we identify some of the factors resulting in a change in the indirect cost rates. In a follow up post, we will provide guidelines on how to use these changes to your business’s advantage.
Improper estimates
Most often, businesses provide an estimate of the indirect cost rates when bidding a contract. When these estimates are incomplete or based on imperfect data, the business will end with a different indirect cost rate when the actual work is performed.
Change in the number of contracts being serviced
An increase or decrease in the number of active contracts or projects will also affect the rate, depending on whether the business is currently underutilizing resources or needs to procure additional ones. If the first is true, the business might see a decrease in indirect costs as direct costs increase. If the second is true, the business will see a fluctuation of indirect cost rates. But, whether the rates decrease or increase will depend on the resources procured and the overall efficiency of the business.
Change in the phase of each contract
Contracts go through several phases. The most commonly used are proposal, performance and close-out. Each phase necessitates the application of either an estimate or the actual indirect cost rates. As we discussed earlier, estimated indirect cost rates are not always accurate, as they depend on the data used at the time of the estimate.
Change in the type of the contracts being worked on
Rarely do contract terms change, beside a change in funding, but the contract mix between fixed price and cost reimbursement types affects the indirect cost rate indirectly. This is especially evident when rates increase from the proposal estimate as businesses usually try to cost-correct to reduce the rates.
Lack of management oversight in managing the indirect costs
Lack of monitoring and actively managing the indirect costs results in inefficiencies developing from an increase in labor or material costs. There is also the monitoring of unexpected additions to the cost pools – i.e., personnel costs associated with staff in between billable projects will increase indirect costs.
Increase in vendor prices
This is an external factor affecting indirect costs, outside of the direct control of a business. It can, however, be managed and vendors replaced, but every business should take into consideration the costs associated with finding the replacement. Sometimes, it is cost effective to bear the price increase rather than change the vendor.
Most of the above instances result in an increase in indirect cost rates. Higher indirect costs result in costs overruns and the need for additional funding, which might be difficult to obtain. Therefore, it is important that rates be calculated quickly and often and applied to the contracts to measure their profitability. A business should also continuously measure their indirect cost rates against their peers to ensure they stay competitive for future bids.
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