Billing Rates - Revise Them Whenever Necessary

We've written about billing rates (see FAR 42.704) before but this isn't a re-post. We are seeing a lot of misinformation passed around and frankly, some goofy positions taken by Government contracting and audit personnel regarding billing rates. Here's the deal with billing rates. Billing rates should be adjusted as often as necessary to reflect contractors' best estimates of final year-end rates. Billing rates are not sacrosanct. They must be adjusted whenever necessary to prevent substantial overpayment or underpayment of indirect costs (see FAR 42.704(c)).

Billing rates established at the beginning of the year can be based on the prior year's actual rates, the prior year's actual rates adjusted for known changes in workload and other factors, discrete forecasts, budgetary data, or some combination of these methods. As the year progresses, estimates become "actual costs" and indirect rates can be derived from actual costs. In all likelihood, actual rates are not going to mirror billing rates. If actual rates are materially different than billing rates, an adjustment is necessary.

If billing rates are higher than "actuals", the Government ends up temporarily paying too much. We say "temporarily" because billing rates are eventually adjusted to final year-end rates and ultimately to negotiated or settled rates.

If billing rates are lower than "actuals", the contractor is not being reimbursed all of its allowable, allocable, and reasonable indirect costs. While adjustment at year-end will also take care of underbillings, contractors are losing out on cash-flow but more importantly, the Government doesn't know what the contract is really costing and may have allocated funds away from the contract.

So, contractors should be monitoring their actual incurred cost rates, measuring them against provisional billing rates. When the difference - either higher or lower - becomes material, send a letter to your contracting officer and/or contract auditor revising those billing rates.

Don't let the Government tell you that you cannot revise your billing rates. Revisions are absolutely required by FAR when billing rates are no longer equitable to either the contractor or the Government.

Provisional Billing Rates - Recent Audit Guidance

Reasonably accurate provisional billing rates are important for both the Government and contractors. Rates that are too high harm the Government. Rates that are too low, negatively impact a contractors cash flow. Whether too high or too low, its difficult to derive an accurate projection of costs and to comply with other contractual provisions such as limitation of costs or limitation of payments.

FAR 42.704 lays out the requirement for establishing provisional billing rates. It states, in part, that the contracting officer or auditor shall establish billing rates on the basis of information from recent reviews, previous rate audits or experience, or similar reliable data or experience of other contracting activities. Additionally, those rates should be as close as possible to the final indirect cost rates anticipated for the fiscal year.

The key point from FAR 42.704 is that the Government is going to establish provisional billing rates, with or without contractor input. It is almost a certainty that if the Government establishes the rates, it will include some form of decrement to reflect potential unallowable costs. It is always better for the contractor to propose provisional billing rates because the contractor will have the best information on factors that will affect future rates.

DCAA (Defense Contract Audit Agency) recently issued new audit guidance for reviewing provisional billing rates. First of all, the Agency states that the development of provisional billing rates is not an audit. That should help expedite DCAA's role in establishing rates and/or reviewing contractor provisional rate proposals. Further, the steps to reviewing rates consist of the following:

1. Notify the contractor and ask whether the contractor wishes to provide any input.
2. Review past audit files for relevant information.
3. Review incurred cost audits and ascertain trends. Although not stated in the guidance, the audit should review unaudited incurred cost submissions as well.
4. Compare prior year billing rates with actual year end rates to see how close the contractors' estimates compare to actuals.
5. Ask for a walk-through of any data submitted by the contractor.
6. Summarize and come up with an estimate.

These are fairly straight-forward tasks and should not cause any undue grief. From the Government's standpoint, provisional billing rates are low risk because the rates will be trued-up at the end of the year after contractors submit their final indirect rate proposals.

Time to Update Provisional Billing Rates

Its a new year and, if you haven't already done so, its time for contractors to update their provisional billing rates (PBRs) - before billings are submitted for costs incurred in January. PBRs should be based on some sort of annual budget, submitted at least annually, but more often as circumstances dictate.

Vouchers and progress payment requests can be returned if submitted without properly established billing rates. Many contractors, especially small businesses without the luxury of having in-house staff to develop and monitor indirect billing rates, know all to well the punishment meted out by the contract auditor or the contracting officer when rates are out of date - rejected payment requests disrupt the cash flow process which dominoes into other problems (like the inability to meet payroll and pay vendors).

When submitting a PBR proposal to either the auditor or the contracting officer, contractors should include a comparative analysis showing last year's actuals, current year to day actuals, and current year budget. Significant differences withing this comparative analysis should be explained in sufficient detail to provide a reviewer some insight into changes.

Contractors need to ensure that their PBRs do not include unallowable costs. Of course, if the rates are based on budgeted information, there will most likely not be sufficient detail to identify potentially unallowable costs. Some contractors take small decrements off the G&A rate to provide for the potential that it will incur unallowable costs. Usually this is an acceptable practice but there are no guarantees the auditors will like it. There are 4,000 contract auditors scattered across 120 offices and while they try to achieve uniformity, it does not always happen.

Monitoring is also a key element to PBR development. Someone in the company must monitor approved billing rates against actual experience to ensure their continued viability. Indirect rates are impacted when business volume changes and contractors have the duty to revise PBRs whenever there are significant changes. Rates can swing up or down. If rates increase, the contractor is hurting itself by not adjusting PBRs upward. When rates fall, the Government is harmed if the PBRs are not adjusted. If the latter happens, you've just signed up for some increased audit oversight.

Provisional Billing Rates

Some Government contractors have been receiving letters from DCAA requesting early submittal of their 2012 provisional billing rates. Provisional billing rates are used in to bill the Government for indirect costs on vouchers and progress payments.

The text within the letters vary a little but state something along the lines of:

In order to expedite the establishment of provisional billing rates prior to the start of the next calendar year, we are hereby requesting you to submit your provisional billing rate packages to our office by such and such a date. By obtaining the packages at this time, we can review and establish rates prior to submission of vouchers to the Government in 2012. By establishing your provisional billing rates prior to the start of 2012, this will ensure minimal delay in voucher processing.

The letter goes on to request that several documents be provided along with the rates including

• 2012 budgetary data for each pool and base cost element
• Year to date rates including amounts by pool and base cost element
• Identification of unallowable expenses by amount and account nomenclature, and
• Estimated 2011 year end rates including pool and base amounts by cost element.

There are several problems with this request. First, in at least one case, it went to a company with no active Government contracts. Second, there is no contractual requirement to submit provisional billing rates this early. Contractors need only submit rates prior to their use. The earliest that these rates will be needed is sometime in February 2012, when contractors bill for January 2012 costs. Thirdly, most small contractors do not prepare future year budgets this early in the year. Calendar year contractors have only eight months of "actual" costs at this point in the year (January through August).

Finally, the letter contains an implied threat. It states that "By establishing your provisional billing rates prior to the start of 2012, this will ensure minimal delay in voucher processing". We ask, why should there be any delay at all, much less a minimal delay. The Government is bound by the terms of cost reimbursable contracts to reimburse contractors in a timely manner. Failing to do so (according to some legal experts) is a breach of contract.

DCAA has been losing both influence and workload while retaining the same level of staffing. DCAA no longer audits proposals under $100 million dollars, the organization does not conduct financial capability reviews any longer. DoD took away their EVMS reviews (except when specifically requested). Non-Defense agencies are looking elsewhere for their audit needs. Sounds to us like the Organization is looking for things to do so now they've decided to tinker around with contractors' cash flows.

When Should Contractors Revise their Provisional Billing Rates?

Back in March, we posted comments on the requirements and expectations for establishing billing rates. You can read that post here. Since then, we have received a number of inquiries as to how often those rates need to be revised. In this post, we hope to answer that question.

The requirements for establishing provisional billing rates (sometimes called interim billing rates) is found in FAR 42.704. FAR states that the contracting officer or auditor shall establish billing rates on the basis of information resulting from recent review, previous rate audits or experience, or similar reliable data or experience of other contracting activities. In establishing billing rates, the contracting officer or auditor should ensure the billing rates are as close as possible to the final indirect cost rates anticipated for the contractor's fiscal period.

As a practical matter, it doesn't really work that way. The contracting officer or auditor rely on contractors to propose their own provisional billing rates and once submitted, will review the supporting data and estimating methodologies and either approve the proposed billing rates or make some adjustments.

The goal in establishing billing rates is to approximate the year-end actuals as closely as possible. As the year progresses, and actual costs become known, estimates of final rates will become easier to determine. One element of an adequate billing system is a process to compare actual rates (or actuals plus estimates to complete) with provisional billing rates and adjust the provisional billing rates if the difference becomes too great. There is no limit to the number of times during the year for contractors to revise their billing rates. Circumstances change throughout the year and significant changes (like losing out on a significant bid) will impact rates.

At the end of the fiscal year, the actual rates (less adjustments for potentially unallowable costs) will replace the provisional billing rates and both the contractor and the Government are even, in theory.

There are no set criteria for determining when established billing rates need to be revised. We often advise clients to get serious about revising rates when it appears that rate trajectory will impact billings by plus or minus five percent. Some auditors see five percent as too high. Since at the end of the year, provisional rates are adjusted to actuals, the impact to the Government or to the contractor, depending upon whether the rates are too high or too low, is limited to the time value of money.

We recommend that small contractors compare actual rates with approved billing rates on a quarterly basis at a minimum. Larger contractors should make those comparisons on a monthly basis.

Provisional Billing Rates

Government contractors, regardless of size, must develop provisional indirect billing rates if they have cost-reimbursable contracts. These indirect rates are forecasts of what contractors believe will approximate their final rates for a particular accounting period (calendar year or fiscal year). The rates are applied to direct costs charged to cost reimbursable contracts and then billed to the Government. Because they are provisional, contractors must set up a system to periodically monitor their actual rates, compare then to the billing rates, and adjust the billing rates if their estimates do not track fairly closely to the actual rates. Within six months after the end of the accounting period, contractors are required to calculate their final rates and true-up or adjust their billings accordingly.

Contractors need to submit provisional billing rates to DCAA at the beginnig of each year for approval. DCAA is tightening up its procedures in this area. Whereas before, DCAA was somewhat lenient, allowing contractors a month or two to submit rates for a new year, they are not so apt to do that any longer. Now they routinely reject vouchers that are prepared without approved provisional billing rates. This can certainly affect contractors' cash flow as it adds several weeks to the process of getting paid.

The Government requires contractors to set up a process for monitoring provisional billing rates so that those rates can be adjusted (either up or down) as required. Some DCAA offices assert that the monitoring should be performed monthly. Others contend quarterly. Still others rely on judgment. The FAR does not perscribe a particular interval. We maintain that the monitoring should be performed more frequently when rates are volitile and less frequently when rates are stable. The nature of the business and business volume fluctuations have a lot to do with rate stability. Mature businesses tend to have more rate stability than start-ups. Contractors with significant backlog tend to have more rate stability than those with little or no backlog.

Usually, the process of calculating interim indirect expense rates is not difficult or time-consuming. Some accounting systems such as Deltech, do this automatically. But even if you're using QuickBooks, it is a simple matter to build a spreadsheet model to calculate rates. Most of our clients on QuickBooks can run their rates in just a few minutes.