Third in a series of three articles, “Budget Building Blocks,” Reprinted with permission by Donald Keninitz, CPA.
In previous articles we covered the importance of developing an operating budget as well as the basic budget building block, direct labor. In this article we’ll examine the remaining components of a comprehensive operating budget, namely, other direct costs (“ODC’s”) and indirect expenses.
By definition, ODC’s are contract-specific. For existing contracts, responsibility for estimating ODC’s is usually vested with individual program or project managers. As with direct labor, each project manager should be required to provide a budget of other direct costs for the current fiscal year. These costs should be broken down by contract (or task), by category (e.g., subcontractors, consultants, travel, etc.), and by month. Since ODC’s normally will have been estimated at the time the contract proposal was generated, obtaining updated estimates usually poses no special problems; however, it’s important that the original estimates be revised to the extent necessary to reflect changed conditions.
The next step is to consider ODC’s associated with potential new contracts, options, etc. The use of probability theory as a tool in estimating costs in such circumstances was discussed previously and will not be reiterated here; however, special mention must be made of the difficulties inherent in projecting ODC’s for potential contracts where RFP’s have not yet been identified. For service contractors, this may not be a problem since direct labor is often by far the largest component of direct costs and usually is a relatively constant portion of typical total contract value. Even so, exceptions may exist when, for example, specialized expertise is required that demands the use of a subcontractor, or when special materials or equipment in substantial amounts are called for in an RFP. For service contractors at least, it’s probably best not to worry too much about such anomalies for the following reasons:
Profit often is not calculated on such costs when they are not part of the contractor’s normal cost structure
The theoretical implication of such costs usually would be to reduce the contractor’s general and administrative (“G&A”) rate (as a result of a larger base, i.e., greater total cost inputs); however, unusual, specialized or nonrecurring costs are frequently excluded from the G&A rate calculation in favor of a separate subcontractor or material handling rate
Accordingly, the impact of possible unusual ODC’s on the budgeting process can usually be ignored for most service contractors except insofar as it is likely to affect items other than profitability, such as cash flow and the need for financing.
The foregoing assumptions may be less relevant for contractors who specialize in facilities management or systems integration. Nonetheless, for these contractors ODC’s tend to be reasonably predictable in proportion to total contract value. It is important in such cases to carefully review past ODC experience as well as to evaluate the types of contracts on which the company intends to propose during the budget period. As a last resort, if it is not reasonable to estimate a constant percentage for ODC’s then the contractor will need to rely on some form of probability analysis. This analysis should consider the possible ODC levels for various types of contracts, the estimated magnitude of each type of potential award, and the company’s likelihood of winning contracts having different characteristics and size.
Once a contractor has established a budget for direct labor and ODC’s it is ready to begin the process of estimating indirect costs. Certain indirect costs, such as fringe benefit expenses and, to a lesser extent, overhead expenses, often bear a reasonably proportionate relationship to direct labor costs. G&A expenses typically will require more careful analysis. Probably the most typical indirect rate structure for small and medium-size contractors consists of a fringe benefit pool, an overhead pool, and a G&A pool. Since this structure is representative of a wide range of contractors, it will serve as the basis of our illustration of the budgeting process for indirect costs and rates.
Generally, the easiest indirect costs to predict are fringe benefits. These generally bear a very strong relationship to labor costs and are thus easily susceptible of estimation once a total labor budget has been established. One way to estimate fringe benefits is simply to use a master labor schedule. This is a schedule that shows for each existing and projecting employee an allocation of their expected work hours into various buckets, such as direct, leave (fringe benefits), overhead (such as supervision) and G&A (general management or other general corporate activity). This is the single most important data element for producing a reliable budget.
Once prepared, the master labor schedule can be supplemented by adding columns for common fringe benefits such as health care premiums, pension and profit-sharing contributions, FICA, unemployment insurance and bonuses. Information regarding compensatory time such as vacations, holidays and sick leave should already have been incorporated in the schedule as part of the labor budgeting process.
The process of budgeting overhead and G&A expenses also begins with the master labor schedule. Many of the expenses normally included in these pools can be estimated on a “demand” basis, i.e., how much of each type of expense will be incurred to support an average full-time (or full-time equivalent) employee. For example, a company can usually use its historical experience to determine estimated usage figures for items such as office supplies, telephone service, postage and so on. Special consideration can be given to existing or anticipated contracts that will create special or unusual demand for a particular type of cost. Certain other costs, such as rent and general insurance are of a relatively fixed nature and are thus known, at least in the short-term.
As with other budget elements, it’s important to consider what effect, if any, significant changes in overall activity volume will have on the basic cost structure. For example, if the receipt of a particular contract award would double a contractor’s size, then careful consideration must be given to the possible need for, among other things, increased office space, greater insurance coverage, and an increase in the level of basic support personnel. Such consideration will likely lead to a change in indirect rates, but the direction of that change will depend on how big the the changes in the indirect allocation bases are relative to the changes in the related indirect pools. Big increases in contract revenue volume – particularly increases that result from additional direct labor – often lead to lower indirect rates because the growth of the allocation bases outstrips the growth of the pools.
Note that forward-looking estimates of activity are especially crucial to any contractor with cost-plus work, as changes in indirect rates will have an immediate effect on the total costs incurred and billed for such work. This requires a contractor to promptly seek revision of provisional billing rates to avoid significant underbilling (bad for cash flow) or overbilling (which creates a liability to the government the contractor may not be prepared to meet, i.e., if cash has already been spent and there’s thus no reserve to cover the liability). Failure to anticipate indirect rate changes leading to under- or overbilling is one of the most common occurrences in government contracting. Additionally, anticipating expected changes in indirect cost rates is key to remaining competitive on cost proposals. A contractor doesn’t want to estimate indirect cost rates in a proposal beyond what they’re expected to be for the periods in which the contract – if awarded – is to be performed. That’s a good way to lose business!
In preparing overhead and G&A budgets, it’s also important to prepare a capital budget. This will enumerate expected property and equipment purchases based on factors such as the need to replace existing equipment and the requirement to support additional personnel based on projected growth. The capital budget, together with existing property and equipment records, forms the basis for estimating total depreciation expense as well as the allocation of such expense to the appropriate indirect cost pools.
In developing a budget, it’s essential to document all of the assumptions used in estimating usage and demand factors and the related indirect costs for several reasons:
To provide for management review of the extent to which the budget is achievable and realistic.
To serve as an aid in defending budgeted amounts to outsiders, such as government auditors
As a means for comparing assumptions with actual experience. Hopefully, this will permit ongoing review and revision of assumptions so that the budgeting process is continually improved and refined.
As a final note, we’ve ignored profit in our discussion. This is because the profit component is: a) contract specific, and b) normally is negotiated based on a percentage of total costs, the determination of which will be facilitated by the budgeting process. In other words profit is a calculated amount that will be the natural byproduct of preparing a comprehensive budget.
In wrapping up this series on budgeting, focus on these three things:
A comprehensive operating budget is essential to becoming and remaining profitable, to ensuring accurate proposal pricing, and in evaluating performance at both macro and micro levels.
It all starts with a master labor budget, as that typically is the biggest driver of other costs, especially indirect costs.
Budgeting must take into account anticipated changes in costs, especially those likely to result from the award of new contracts and the expiration of existing ones.