(Editor’s Note. The following article is part of our ongoing practice to provide real life case studies from our consulting engagements that we believe will have relevance to our readers. As usual, we disguise the client name – referring to “Contractor” – and other private information. We were asked to evaluate Contractor’s indirect rate structure with respect to whether it provides the best possible indirect rates for pricing its government work, consider alternatives, conduct a quantitative analysis of viable alternatives and once the best candidate was selected, consider how expenses previously charged to one pool could be charged to another. The following is a summary of our analysis.)
Background Information
Contractor is primarily a professional services company with a small portion of prototype work that has a mix of federal government (80%) and commercial clients. The government work is with several government departments with one large cost type contract having significant subcontract work as well as time and material and fixed price work having little to no subcontract work. Currently, Contractor has three indirect rates: (1) overhead allocated on a direct labor cost base (2) G&A allocated on a value added base consisting of all costs excluding direct material and subcontracts costs (M&S) and a (3) subcontract/material handling rate allocated on a direct subcontract and material cost base. The M&S rate is a little more than 1 percent where Contractor believes it could charge the government a higher rate if its cost structure provided for it but the government would not be happy about an add-on exceeding 10 percent.
Alternatives
We generated five alternative indirect rate structures that we believed were worthy of consideration. Though there were variations within each here is a simplified version of the alternatives:
A. Current method.
B. Increase handling rate. This alternative kept the current structure but reassigned dollars to different pools. (At this stage, we did not attempt to determine whether the reallocation of costs could be justified but only reassigned costs to see whether there might be a better result for pricing purposes.) We deducted an amount from the G&A cost pool and added these costs to the M&S pool so the result would be to double the M&S rate.
Alternatively, costs could be taken from the overhead rather than G&A pools or a portion from each.
C. Eliminate handling rate. Both the G&A pool and base are increased to absorb the costs that were included in the M&S pool and base. A modification might include increasing the overhead pool for the costs included in the M&S pool and increasing the G&A base for the subcontract and material direct costs.
D. Reduce the G&A rate to a more palatable 10%. Under all three alternatives above, the result was a G&A rate far in excess of the 10 percent level the government would accept as an add-on to subcontract costs. In order to achieve the desired 10 percent rate, approximately $700,000 of costs included in the G&A pool would have to be reallocated to overhead which would lower the G&A rate by both (1) decreasing costs in the pool and (2) increasing the costs in the G&A base.
E. Charge fringe benefits direct as a percentage of direct labor and change the overhead base to direct labor plus fringe. This change provides the appearance of lowering the overhead rate (both direct costs and fringe costs rather than only direct costs are in the overhead base) and making changes identified in D above would yield the 10% G&A rate.
Sensitivity Analysis
We conducted a three step analysis to determine which of the five approaches would provide for maximum recovery.
1. The first step consisted of reassigning costs from one pool and base to the other, without considering whether the reallocations could be justified. For example, we moved costs from the G&A pool to the M&S pool under Alternative B approach and we moved $700K of G&A costs to overhead under the Alternative D approach.
2. Once we made the reassignments of costs we took the second step of calculating the resulting indirect cost rates.
3. After verifying the past mix of direct costs would not vary significantly in the future, we used the most recent incurred cost proposal data to lay out the mix of costs experienced under most large contracts in each category of contract type (e.g. cost type, T&M, fixed price). Next we applied the resulting indirect cost rates generated from Step 2 above to the appropriate direct costs for each contract and then compared the total cost recoveries under each of the five approaches.
The results were clear – Alternative D provided the best cost recovery under the large cost type contracts that included significant subcontract costs while the current method provided the best results for T&M and fixed price work where there were minimal subcontract costs. Since the cost type work with significant subcontract costs were expected to predominate near future work (next 2-3 years) Alternative D was the preferred structure.
It is one thing to see the benefits of Approach D – eliminating the M&S rate and reallocating $700K of G&A costs to overhead – and quite another to make the changes required with, hopefully, gaining acceptance of the changes by the government. Could the reallocation of $700K of G&A costs to overhead be made? The next step was to examine the G&A costs and see whether a reallocation of costs would be considered to be reasonable on cost allocation grounds. Our working definitions of overhead and G&A are quite common – overhead costs are indirect costs not identifiable with any one particular project but incurred in support of projects while G&A costs are those indirect costs more closely associated with supporting the company as a whole. The list of significant G&A costs and our analysis of whether some or all of the costs could be reassigned to overhead follows.
Contract administration. Currently, contract administration costs are included in the subcontract handling pool. Since those costs need to be reassigned, the question is do they belong in overhead or G&A. Though both treatments are fairly common, one can argue they belong in overhead since contract administration normally supports contracts (hence the name) as opposed to the company as a whole.
Office Lease. Again, both overhead and G&A treatments are common. More precision can be obtained by establishing a facilities cost pool where not only office leasing costs but also other facility related costs like utilities, repairs and maintenance, landscaping, any building related depreciation would also be included in the facilities pool. Then those costs could be allocated to overhead versus G&A on a square footage usage basis. An ideal method would be to somehow calculate the space taken up by G&A versus overhead functions. However, when allocating service or cost center costs, less than ideal solutions are usually sought. For example, an acceptable basis might be headcount or labor cost basis where, for example, the percentage of direct labor and overhead related employee expenses versus G&A labor expenses might form the basis of allocating the facilities related costs that would be a surrogate measurement for a square footage allocation.
Business Management. If by “business management” you mean marketing and sales, those costs are most likely oriented to G&A. However, if by the term you mean administrative or contract related supervision, then that may be primarily overhead.
G&A Salaries. It’s quite common to include the costs of entire functions into one pool However, it is probably more accurate to split out the functions and assign the corresponding costs to appropriate pools. For example, the head of HR may properly be included in G&A because their activities relate more to overall corporate activities while the HR staff time is more commonly focused on supporting direct labor personnel and hence properly allocable to overhead.
Legal fees. Similar to G&A salaries, either the head of the legal department or certain functions of outside attorneys may be related to overall corporate matters and hence G&A (if significant, these efforts may be unallowable if related to mergers and acquisitions, corporate financing, etc.). However, many legal duties are more closely related to support of projects (employee suits, environmental issues, vendor disputes).
ESOP. These costs, like payroll taxes and fringe benefits should follow the labor costs if they are assigned to specific individuals.
Depreciation costs. Depreciation costs should, of course, follow the assets so treatment of such costs should be based on usage of the assets. Building depreciation should be included in the facilities cost pool. Computer depreciation costs could be allocated by headcount, especially if everyone has similar computers while shared assets like printers, reproduction and servers might follow computer depreciation cost allocations. Alternatively, since most asset use is derived from headcount or labor related costs, such costs may be included in the facilities cost pool if a similar basis for allocating facilities costs is logical or a separate IT cost pool may be created where allocation could be on a similar allocation basis. Exact or ideal precision is not required or, in most cases, even desired since the effort and cost of such precision is usually high – only reasonableness of assumptions is needed.
Professional Insurance. Though it is not uncommon to treat all “insurance” costs the same, the purpose of the insurance is a better gauge. So, whereas general liability insurance may more properly be considered G&A, professional insurance that applies primarily to project employees is more logically allocable to overhead.
Recruiting and relocation. These costs certainly follow the people they are associated with. Recruitment and relocation of employees primarily engaged in project or overhead functions should be allocated to overhead while if related to hiring a corporate executive more properly to G&A.
Office staff. Staff may be assigned to one or multiple functions. If primarily in support of either G&A or overhead personnel, their costs with associated fringe benefits should follow. If mixed, then either assignment to one pool or the other would be acceptable or for more precision, ask them to use timesheets if it is common for non-direct people and assign costs to the efforts reflected on the timesheets.
Internal accounting costs. Though often simply charged to G&A, a breakdown also can make sense. For example, like HR costs discussed above, the CFO and corporate controller might be considered G&A because their efforts are primarily related to the company as a whole (e.g. corporate policies, corporate financial statements) while subordinate accounting staff are more commonly associated with support of projects and hence overhead (e.g. payroll, AP, AR). Outside accounting and audit fees, on the other hand, are more commonly considered to be G&A costs.
Business Development. This function is usually G&A because costs of sales and marketing are generally associated with expanding the overall company base. It is not unreasonable, however, to distinguish between new contract work – either commercial or government which would be charged to G&A and expanding existing work which might be considered overhead. However, it should be realized that charging any “marketing” or “sales” costs to overhead is unusual and hence may generate a red flag.
Though our discussion with our client about how to divulge the changes that adoption of Alternative D would entail is beyond the scope of this article, all contractors need to consider the proper timing of such a significant change as the adoption of alternative
D. When disclosure is made to the ACO and or DCAA, it is likely that a write-up detailing the changes, why they were made, justifying them and showing a gross cost impact on the changes can be expected. Also, depending on the timing of the change, there may need to be an adjustment of provisional billing rates and or an adjusting invoice where a DCAA audit can be predicted.
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