(Editor’s Note. Though we have often discussed in these pages the pros and cons of implementing a particular indirect cost rate we areoften asked to provide a range of options for a company to choose from. Helping clients select the best possible indirect rate structure has become an increasing part of our consulting practice. Though the motivation to avoid assertions of improper cost and pricinpractices as well as a desire for more accurate accounting is often the motive to consider alternative rates we often find pricing strategies to also be a big motivator where such considerations seem evenly divided between increasing recoveries on new contracts without affecting existing contracts and lowering indirect rate allocations to be more competitive. Though we have addressed this issue inthe past we thought we would assemble some of the most common indirect rates to consider. The first part of this article addressesmanufacturers but we find the principles discussed are applicable to all firms while the later section addresses all contractors’ circumstances such as services and even construction firms. We have used numerous texts to discuss these (especially “Accounting for Government Contracts”, edited by Lane Anderson) and our own experiences to see what have been proven useful to our clients.)
Common Manufacturing Pools and Bases
Generally costs are not recoverable on new contracts unless the indirect cost pools and bases are pre established. For example, costs of handling material cannot be proposed or recovered unless they are separately identified and established in a material handling pool before the proposal is prepared. Manufacturing firms can be considered labor, material or subcontract or capital intensive and each often calls for using different types of indirect rates.
Labor Intensive Firms
Some firms may use a single manufacturing pool while for many more diverse and complex organizations additional cost pools may be appropriate. Separate pools are most commonly established by departments that may include fabrication, assembly, tooling, testing quality assurance, inspection, machine shop, paint shop and welding. Though we rarely see indirect rates for each department, multiple rates are not unusual depending on their relative significance to others. Though multiple rates could be used, one or two canbe decided upon, especially when there is no material differences between rates in multiple departments. On the other hand, more pools than are necessary may be used even when there is little difference when companies, for example, want to track activity under different managers.
When a firm is labor intensive, the allocation base used for most cost pools are direct labor hours or directlabor dollars. Labor dollars have tended to be more favored because it is not affected by inflation – labor costs increase in proportion to the pool - while labor hours will tend to increase rates under inflationary conditions. The drawback to using labor dollars occurs when the labor base includes a wide range of wages and salaries resulting in increased allocation to higher paid labor activities. Generally, if the pool of expenses to be allocated are more closely related to the number of employees then a labor hour base is preferable; ifthe pool is more related to compensation then a labor dollar base should be used. Some cases (e.g. Brown Engineering) have ruled that premiums, bonuses andother pay differentials should be excluded from a direct labor dollar base.
In manufacturing companies where labor is decreasing as a percent of total cost firms may adopt activity based costing applications that have been in vogue for some time now where labor bases give way to other allocation schemes. Common bases are machine setups, set-up hours, standard processing times, items inspected, engineering changes, drawings, routing, etc.
Material Intensive Firms
When a firm is material intensive then material related cost pools should be considered. Material related costs might include material handling costs (e.g.unpacking, inspection, moving from and to storage)as well as purchasing and ordering. The governmentmay object to allocating a significant amount ofmaterial related cost on a labor base asserting there is little correlation (i.e. casual/beneficial relationship).Using a labor base for material oriented costs may also be inconsistent with a company’s goals – for example, for contracts with a relatively heavy material component and lighter labor cost, recovery would be less. Conversely, contracts containing a relatively high labor component may attract a disproportionately large amount of indirect costs which may or not be desirable. If material is used uniformly on all jobs then a separate pool is unnecessary. Also, if labor costs are insignificant, then a material base may be appropriate for all indirect costs. Multiple material related pools may also be necessary - for example,when both material and customer-furnished material are significant and their proportionate use on contracts differ, then separate pools and bases may be needed.
A variation of a material related pool is a subcontract administration pool. A separate pool may be needed if subcontract related expenses are significant and are not incurred in the same ratio as material costs. We have seen a wide variety of costs included in subcontract handling pools from ordering and administering subcontracts to proportionate shares of engineering, marketing and research and development costs and other services. Generally,direct subcontract costs are the allocation base.
When activity based costing is used, potential allocation bases for material costs may include the size of material, number of items, number of times material is moved within a facility, number of purchase orders, etc. We have seen numerous pools of material related costs divided by a variety of materials wherethe cost of one category was allocated to contracts based on number of purchase orders while the cost of another category was allocated to contracts on the number of items handled.
For capital intensive companies, other allocation pools and bases may be appropriate. Capital intensive manufacturing usually translates into equipment intensive so pools and bases are more oriented to equipment usage. For example, the costs related to a machine shop may constitute a separate pool using a machine hour base. DCAA has come up with guidance for allocating special facility costs wherethere is a preference, in descending order, for (1) use basis for allocation where pre determined rates areset for a year (2) allocation based on direct chargingof specifically identifiable costs and allocating the rest to overhead accounts and (3) allocation to normal overhead cost pools.
Other Manufacturing Rates
Spare Parts. To price spare parts more accurately, you may want to pool costs associated with handling,packaging, shipping, storing spare parts and allocating them on such bases as cost of spare parts or number of items shipped. In selecting a base, you need to consider circumstance – if number of items on an order can vary widely inequities can result if the allocation base is number of shipped items.
Field Service Pools. When field or customer services at off-site locations are significant and especially whensuch activity for different products or projects are unequal then one or more field service cost pools maybe necessary including training of customer personnel,warranty repairs, liaison with operating personnel aswell as fully burdened labor costs including allocations of fringe benefits, facilities costs, etc. The allocation base is commonly direct labor dollars or hours.
Process Cost Pools. Sometimes costs are accumulated by the various processes a product goes through before completion rather than on a job or contract basis. Indirect costs not identified with a process must still be allocated to output or equivalent units underthe full-absorption concept of government accounting. Though a direct labor base is commonly used, rates can sometimes be quite high especially whenthe labor component is small. Alternative allocation bases might be machine hours, units of output of product cost.
Service Cost Pools
In addition to actual manufacturing activities, services are often provided within both services and manufacturing firms. For example, an engineering group may provide production and design services.When the costs of these services are included in indirect manufacturing or service overhead pools, they can lead to problems with government auditors and customers who are seeking the lowest possible price. For example,if an indirect manufacturing pool includes both manufacturing and engineering services, a direct labor dollar base could assign a disproportionate amount of indirect costs to engineers due to their higher salaries.The government might object if a government contract receives a high amount of allocations due to an unusually high use of engineering services. Allocating excessive indirect costs to engineering services could result in non-competitive prices for contractors seeking government business. The solution might be to accumulate engineering expenses into a separate pool(or even multiple pools for, say product, design andsoftware engineering) if the resulting rates would besignificant.
Or, consider a service firm with multiple offices. If the government furnishes office space, utilities orsupplies it would be inequitable for facilities costs to be included in an indirect cost pool and allocated to contracts for which the government furnishes some or all of these things. Not only would the government object to being overcharged but the contractor would likely not be cost-competitive when trying to win new business. In this case, it is quite common for contractors to keep two types of indirect costs: (1)indirect cost pool(s) at the home location and (2)indirect cost pools at the sites of specific customers.Overhead costs (we will get to G&A costs later)common to all contracts would be accumulated at the first category and costs specific to particular sitesat the second category. For example, the home site pool might include rent paid for the home-office space plus fringe benefits for all indirect home officeemployees while the customer specific site mightinclude no rental costs but all fringe benefits of indirect employees working at that site.
The allocation base for the services we have been discussing is usually direct labor hours or dollars. This is consistent with CAS 418 which prefers use of a labor allocation base when the indirect costs consist of management or supervision activities. Either a labor dollar or hour base is appropriate and if the benefits outweigh the effort, two separate pools – one with a labor dollar and the other a labor hour – maybe used. Few other bases are usually appropriate though one variation might include fringe benefit costsof direct employees in the direct labor dollar base.Though the amount of costs allocated to a particularcontract would most likely not be significant, it would have the cosmetic appeal of a lower indirect cost rate.
Fringe Benefit Pool
Fringe benefit costs include payroll taxes, pension contributions, medical plans, life insurance, employee welfare, etc. Often fringe benefits are not segregated in a separate pool but simply accumulated with other indirect costs. For example, the fringe benefits forboth direct and overhead labor are accumulated in an overhead account and the fringe benefits for G&Alabor accumulated in a G&A pool.
Whether it is to appear to lower indirect rates, focus management attention or achieve a higher level of precision, contractors may often decide to use a separate fringe benefit pool. Use of a direct labor dollar base is not uncommon even though it is rarely precise. Unless multiple fringe rates are adopted(which is quite rare) everyone becomes accustomedto some level of imprecision since some benefits vary according to the number of employees (e.g. fixedmedical insurance per employee) while other benefits vary according to salary (e.g. pension costs based on employee earnings).
Multiple fringe benefit rates may be desirable when fringe benefit rates vary significantly between groups of employees. Common examples include varying state related taxes (unemployment, workers compensation) or different union agreements between sites. Probably the greatest incentive for more sophisticated treatment of fringe benefits is the increased use of less than full time employees. Fulltime employees may receive all fringe benefits while other less than full time employees may receive alimited range of benefits – say vacation and taxes butno health benefits or pension and still others(sometimes called “variable” or temporary employees) may receive no fringe benefits exceptpayroll taxes. One solution might include accumulating fringe benefits in layers or tiers wherethe first pool would consist of only statutory benefits applicable to all employees, the second pool would consist of benefits applicable to the less than full time employees and the third pool to variable employees.
Support Pools
Both manufacturing and service firms have a wide variety of potential support pools. Rather than include support costs in overhead pools and crediting the cost portion of revenue to the pools when they are charged to contracts, contractors can eliminate both the associated costs and revenue of certain supportfunctions from overhead and G&A pools and treat them separately in service centers. Some of the more common support pools include:
Occupancy costs. Occupancy costs include building depreciation, amortization of leasehold improvements,maintenance costs, utilities and other related costs. The occupancy pool is usually an intermediate pool that isallocated to other indirect cost pools rather thandirectly to final cost objectives. Square footage is the most common allocation base. Though less common,number of employees (when area and type of spaceused by each employee is similar) or cubic space (whenut ilities costs are significant and areas with high ceiling use more than those with low ceilings) can be used when the basis is reasonable.
Computer Operations. The costs include computer operations for equipment, supplies and personnel and are commonly associated with (1) business applications such as accounting and payroll or (2)scientific or engineering applications. A large computer operation might justify creating two pools where accounting functions could be charged to G&Aand scientific functions charged to cost objectives that benefit most. Selection of appropriate allocation bases for the second type of costs can be problematic
– use of computer time can be difficult because computers process several jobs at once while other traditional usage measures (e.g. central processin time, number of input or output channels, amountof core storage, number of lines printed, number of records handled) need to be carefully selected and monitored and may have less relevance these days.
Other Support Services. Other frequently used indirect cost pools collect a wide variety of service costs. Common examples include: (1) reproduction cost pools consisting of costs of copying machines,machines operators, supplies allocated on copies mad (2) graphics, art and photographic departments allocated on items produced (3) communications costs such as telephone, cell phones, etc. allocated on the adcount (4) vehicle related expenses allocated on mileage. In addition, special facilities (e.g. wind tunnels, heat treatment, environmental chambers and microelectronic centers) are also common and a usage allocation base such as time spent or number of items processed are usually preferred by auditors over labor bases.
Charge Rates. In the past, the government preferred that all costs in each support center be allocated to benefiting users using a provisional rate that was adjusted at year end for actual costs by charging or crediting the center’s costs for over or under allocations. Methods used to accumulate pooled costs and allocation bases have always been a major bone of contention between auditors and contractors so establishing charge rates using commercial prices has gained in popularity. This is generally acceptable aslong as contractors can show their costs are similar or above commercial costs.
General and Administrative Pools
G&A costs, sometimes referred to as the remaining costs, are those expenses not identifiable with particular cost objectives but necessary for the overall operation of a business that include the costs of management, legal and accounting, business taxes,selling and marketing and similar costs. In a corporate structure, the firms’ G&A expenses may consist of costs at the business unit as well as allocations from the group and corporate level. G&A expenses are allocated based on some measure of the activities of the entire organization. CAS 410 states the preferred bases are the total cost input base, the value added base (excluding material and/or subcontracts) or asingle element base (commonly direct labor).
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