Failure to anticipate indirect rate changes leading to under- or over-billing is one of the most common occurrences in government contracting.
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Once a contractor has established a budget for direct labor and other direct costs (ODCs), 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.
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.