As your company grows and evolves, you may find yourself in need of an indirect rate structure change. Here is some background on defining indirect vs. direct cost structures, as well as tips to help you avoid a rate run-in with DCAA.
As a government contractor, not only must you keep your business competitive in the marketplace by knowing your cost of doing business, but you must also make sure your indirect rate structures achieve compliance with government regulations.
Developing indirect rate structures is complex and time-consuming and the subject is often misunderstood among contractors. However, it remains a high profile item for regulatory agencies such as DCAA. And, when your company grows, you may naturally find yourself in a grey area regarding rate structures. Let's look at an example to illustrate this point.
Suppose a company starts off as a professional services firm with employees of whom many hold advanced college degrees. The corporate fringe rate for such a firm is based on a package of fringes that are inherent to attracting the best talent. Then, the company opens a new business line that provides operations and maintenance services staffed by less highly educated wage earners.
Consequently, the company is now dealing with a wide range of pay grades and benefits packages. It would not be wise to blend these two different business lines into a single fringe cost structure (pool) because the pay rates and associated benefits costs are quite different. Keeping them together in a single pool of accounts would create distortions in the company's indirect expense rate structure for fringe benefits. Now you get the idea of how quickly rate structure issues can change as your business model changes and therefore become more complex with multiple indirect expense pools and so forth. Acquiring some basic knowledge about how indirect rate structures work and their effect on your lines of business can help you justify a change to your proposed rates to DCAA and other government auditors.
Direct Vs. Indirect Costing
A direct cost is any cost that can be identified to only one cost objective, and it is normally required for contract performance. "Cost objective" is a regulatory term that may include a contract, project, task, or a contract line item. It can also include individual indirect projects such as a bid and proposal or even an independent research and development project.
An example of a direct cost are the raw materials that have been purchased exclusively for one cost objective. Another example is the time spent by an employee working on one cost objective. In other words, you can draw a direct line from the item or time spent to the cost, with no tangents along the way.
On the other hand, indirect costs are those costs that are not identifiable or incurred for the goal of one cost objective. An example is a manager who is overseeing multiple contracts; it would be difficult to identify his time devoted to each project, so his time would be charged to overhead. Or, another example is a piece of equipment that is used on multiple projects; this purchase would also be difficult to split among various projects. So, these costs are charged to indirect cost accounts.
Defining costs is relatively straightforward, but consistently coding or charging costs either to direct or indirect accounts can be challenging. This challenge is amplified when your accounting software's chart of accounts makes no allowances for such distinctions.
Being consistent in recording expenses is crucial; failing to meet this consistency principle as set forth in CAS 401 is sure to bring problems with DCAA, not to mention the potential of distorting your indirect rates.
The best way to address indirect rate structure challenges is to invest in an industry specific accounting software program that has the built-in functionality to maintain indirect rate structures that are capable of supporting multiple business lines. Whenever your software can help you to segregate direct costs from indirect costs while calculating your indirect rates on a periodic basis means you have one less thing to worry about when it comes to compliance.