Contractors often must supply cost and pricing data in contract proposals. There are three basic components to such data: direct costs; indirect costs; and expected profit. While competitive considerations affect all three, companies frequently do most of their agonizing over indirect costs. This is due to uncertainty as to what constitutes a “competitive” rate, or set of rates. Accordingly, contractors covet knowledge of competitors’ rates, which tend to be closely guarded. What they don’t realize – or at least fail to acknowledge – is that trying simply to mimic or beat a competitor’s individual indirect rates may be ineffective. What is much more important is to know your company’s direct cost base levels – especially for direct labor – and your indirect rate multiplier and how it compares with the competition.
Let’s start with a brief review. A company establishes indirect cost pools for accumulating its indirect costs. These pools seek to classify costs by function, activity, location, or operating division. In establishing a cost pool, a base is chosen for distributing the costs to the contracts that benefit.. This is known as an allocation base. Because companies differ in the number and composition of their pools and allocation bases, direct comparison of a rate for one company to the “corresponding” rate of another can be dangerous. An example will help to illustrate this.
First, imagine two hypothetical contractors, each of which uses a fringe benefit pool, an overhead pool, and a G&A pool. Further imagine that the two companies incur substantially identical indirect costs. Now, suppose the first company decides to accumulate all fringe benefits in a separate pool and then allocate them using direct labor dollars as a base. The second company elects to accumulate fringe benefits in an intermediate pool and then allocate them on the basis of total labor, rather than just direct labor. This results in the inclusion of a pro-rata share of fringe benefits in the overhead and G&A pools. Obviously, the computed fringe benefit rate of the second company is likely to be lower since the fringe costs are being spread over a larger base. On the other hand, this company will have comparatively higher overhead and G&A rates, since those pools will include additional costs, i.e., fringe benefits. Trying to compare the rates of the two companies would be futile unless one also had knowledge of the underlying allocation methodology. This brings us to the use of the indirect rate multiplier.
The “multiplier” represents the effect of burdening one dollar of direct labor with all of the indirect costs of a company using its established rates and allocation bases. For example, if a contractor has a fringe rate of 30% ( applied to direct labor), an overhead rate of 40% (applied to direct labor plus allocated fringes), and a G&A rate of 10% (applied to all other costs), it’s multiplier would be 2.02, calculated as follows: 1 + (1 x .30) + (1.3 x .40) + (1.82 x .10). In the example above, the companies would have identical multipliers even though their individual rates would differ.
But even multiplier comparisons can become more complicated when one of two hypothetical competing companies with identical cost structures maintains both company site (offsite) and government site (onsite) overhead pools while the other doesn’t. In theory this situation should be relatively rare, since the factors that drive the first company – call it Contractor A (and call the second Contractor B) – to maintain two pools should also result in Contractor B doing so as well, but things aren’t necessarily that cut-and-dried. Contractors have broad latitude in determining how to structure their indirect rate pools, and one may conclude that a separate onsite overhead rate is called for while the other believes a single rate is sufficient.
In the foregoing circumstances not only will both of Contractor A’s overhead rates differ from Contractor B’s single rate, so will its multipliers – it now has two – depending on whether a particular contract is to be performed offsite or onsite. And not only will be they be different, one of Contractor A’s multipliers is likely to be lower than Contractor B’s single rate. That’s because we’ve stipulated that both contractors have identical costs, but haven’t assumed they will allocate their indirect costs using identical pools and allocation bases. Assuming Contractor A’s pool structure will withstand DCAA audit as being appropriate in the circumstances (as it likely will since it probably more accurately associates costs with the contracts that cause or benefit from them), Contractor A can be seen to have accommodated its rate structure – and hence its multipliers (emphasis on the plural) – to the specifics of the work it performs on various contracts, while Contractor B hasn’t. Since work performed at the government site will typically be burdened with less overhead, since the government is providing the facility, its government site rate will be lower than its company site rate, as will its multiplier for such work. Naturally, this places Contractor B at a potential competitive disadvantage on work to be performed at government sites.
Now let’s try another example, one that’s not uncommon but is often overlooked when playing the comparison game. Assume our two hypothetical companies have identical indirect costs, but that Contractor A pays higher wages to (only) its direct labor employees. Further, let’s suppose each maintains a separate fringe pool. Even though they provide identical fringes, Contractor A will have a lower fringe rate because its direct labor base (and thus its total labor base) is higher. Moreover its multiplier calculated through the fringe state will be lower as well, even though its total cost for a dollar of its direct labor will be higher. Since this may sound counterintuitive, we’ll use an example.
Assume the following facts:
Both contractors have 100 employees, split between 80 direct and 20 indirect
Contractor A pays its direct employees an average salary of $75,000
Contractor B pays its direct employees an average salary of $70,000
Both contractors use 2,000 hours for computing direct labor rates
Both pay average indirect salaries of $50,000
Both incur total fringes of $2,000,000 (remember, they have the same number of total employees) and use a separate fringe benefit indirect rate pool
Both have total – apart from allocated fringes – overhead of $2,000,000 and G&A of $750,000
Now let’s do the math. Contractor A will have total labor cost of $7,000,000 (80 x $75,000 plus 20 x $50,000). Its fringe rate will be 28.57% ($2,000,000 / $7,000,000). Its hourly direct labor rate before fringes will be $37.50 ($75,000 / 2,000).
Contractor B will have total labor cost of $6,600,000 (80 x $70,000 plus 20 x $50,000). Its fringe rate will be 30.30% ($2,000,000 / $6,600,000). Its hourly direct labor rate before fringes will be $35.00 ($70,000 / 2,000).
If one wasn’t aware of the difference in salary structures it would be easy to conclude that Contractor B is more expensive, because it has a higher fringe rate, 30.30% vs. 28.57%, and a higher fringe multiplier of 1.3030 versus 1.2857. But that’s not true.
One hour of Contractor A’s direct labor burdened with fringes will be $48.21. ($37.50 x 1.2857).
One hour of Contractor B’s direct labor burdened with fringes will be $45.61 ($35.00 x 1.3030).
Contractor B actually has a significant fringe-burdened direct labor cost advantage over Contractor A even though focusing on just the fringe rate might lead one to conclude otherwise. The point here is that sometimes contractors obsess over indirect rates and costs without giving due consideration to competitors’ direct costs.
There are a couple of conclusions to be drawn even from these very simplified examples. First, it’s generally a mistake to focus only on indirect rates when evaluating a company’s competitiveness. A better method is to consider the overall multiplier any given contractor is able to apply to a given potential contract. Second, even multipliers can be deceiving if one company has different base level direct costs. Too often contractors conflate cost-competitiveness with having lower indirect rates than a competitor, when rates don’t tell the whole story. Maintaining a competitive cost structure requires consideration of multiple factors, including direct labor cost competitiveness and development of an indirect rate structure that allocates costs to activities in line with the competition. In the end, the contractor with lower costs, not the appearance of lower costs, will come out ahead.
Editor’s note: For an elaboration on the last example above that illustrates the potential pitfall of relying on comparisons of individual indirect rates, or in some cases even on overall indirect rate multiplier, see the Excel spreadsheet (the link is on the main “Articles” page) that extends the example all the way through to the final burdened labor costs for Contractors A and B, and their overall multipliers. The math gets a little too complicated to allow for clear explanation in a narrative, but here’s a spoiler alert: Contractor A has an overall direct labor multiplier of 1.96 compared to 2.03 for Contractor B, yet the cost of one hour of direct labor for Contractor A is $73.44 vs. $70.94 for Contractor B.