Rose Report: Issue 24

Understanding Direct Costs is More Important Than Ever

issue-24-pic-story3To be able to compete in the increasingly price-sensitive government contracting space, you have to understand your financial statements exceedingly well. In the past, source selection committees had the discretion to choose vendors that had unique skills or that otherwise offered best value. Today, the environment is trending towards lowest price that is technically acceptable in many of the service areas.

That makes managing costs and mastering the art of pricing proposals all the more important.

While splitting costs into direct and indirect categories is a familiar practice, the need to tighten cost structures means that now is a good time for government contractors to take another look at indirect costs.

Differentiating a direct cost from an indirect cost is somewhat intuitive. Direct costs are directly attributable to revenue generated while indirect costs are costs that can benefit multiple objectives and are not directly traceable to a particular contract. The three standard indirect cost categories, generally referred to as cost pools, are fringe, overhead, and general and administrative (G&A). These pools can split into numerous branches and sequels, especially in larger organizations.

The following are several aspects of indirect costs that increase the complexity or can significantly impact the rates:

  • Remove unallowable costs from indirect cost pools. The government will not pay for certain expenses which include interest, lobbying, gifts, entertainment, and certain bonuses, so none of these expenses should be rolled into any indirect costs billed to the government. There are various regulations that govern allowable and unallowable costs, so you need to determine which guidelines apply to your business and specific contracts. The Federal Acquisition Regulations (FAR) and OMB Circulars are widely referred to and explain in detail which costs are unallowable. Be aware that there are some gray areas that may require further analysis. From a business perspective, managing unallowable costs is important as they are being funded out of the profit component of the rate charged to the government.
  • Understand the concept of labor dilution. Labor dilution refers to the concept of computing an “effective hourly rate” for an employee. For example, the annual compensation of a full time salaried employee would normally be divided by 2,080 hours to compute a projected hourly pay rate. If they actually work more hours, their effective hourly pay rate would be lower. A government compliant accounting system must be capable of calculating this rate, in some form, throughout the year. Depending on the method utilized by a company, the government might reimburse at the effective hourly rate in a Cost Plus contract situation.
  • Refine the approach to indirect costs as an organization grows. It may be necessary to add sophistication to an indirect cost structure by adding additional indirect rate pools beyond the ones mentioned above. This becomes necessary to enable an organization to compete effectively in the marketplace. For example, over time a significant portion of work performed on a government contract may be done at a government facility. As a result, certain indirect costs such as rent and office expenses would not apply to the members of the team working on the client site. In this case, an organization would create a separate pool for employees working on-site at the client facility. It’s important to think about the causal-beneficial relationship when establishing indirect pools. The indirect cost structure should be flexible enough to create competitive bids while fairly reflecting the underlying cost structure.
  • Establish provisional rates. Establishing an annual budget for the upcoming fiscal year is not only a critical tool for managing the business it is a key element of a compliant government accounting system. The budget establishes the provisional (forecasted) indirect rates upon which price proposals will be developed. During the fiscal year it is important to compare the actual indirect rates to the provisional ones to determine if adjustments to pricing are necessary.

Contractors should remember that direct and indirect costs are part of a government compliant financial reporting system, that if set-up and functioning properly, provides meaningful information to help manage the business. As with all accounting, without the ability to understand and interpret the results it is very easy to get lost in the details. Rose Financial Services can help provide clarity to the financial results which enables the business owner to focus on growing the business.