Friday, July 11, 2014

Capping Your Indirect Expense Rate(s)

Sometimes contractors, especially start-up contractors, have highly volatile indirect rates. We noticed an extreme case not long ago where the G&A (General and Administrative) indirect expense rate went from 24% to 354% to 63% in a three year period. The G&A pool costs did not change significantly but the allocation base swung wildly.

This makes it very difficult for the Government, when contemplating a cost-reimbursable contract, to accurately forecast contract costs and to budget for expenditures accordingly.

To protect against such situations, the Government will sometimes propose to cap a contractor's indirect rates - to negotiate indirect  cost rate ceilings and incorporate those capped rates into the contract. Sometimes the contract auditor will make such a recommendation, sometimes its the contracting officer who makes it during contract negotiations.

Sometimes a contractor will propose to cap its indirect rates. Usually this is an effort to enhance its competitive position in a particular circumstance by basing its proposal on indirect cost rates lower than those that may reasonably be expected to occur during contract performance, thereby causing a cost overrun.

Other situations where it may be prudent to cap indirect rates in a contract include

  • a new or recently reorganized company where there is no past or recent record of incurred indirect costs
  • where a contractor has optimistically forcasted a lot of new work and the Government is skeptical that it will materialize, as scheduled.

Contractors that agree to capped rates need to understand the risks and consequences. Missing the mark on indirect rates can easily and quickly eat up whatever profit is going to be earned. Costs beyond the profit amount will have to be paid by someone else and contractors need to determine the amount of resources it can afford to use to defray unreimbursed costs. Many companies have suffered long-lasting negative financial impact from agreeing to capped rates.

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