What is an indirect rate?

One of the most perplexing aspects of cost accounting for government contractors is understanding indirect rate structures that are compliant with regulations. The Federal Acquisition Regulations (FAR) and Cost Accounting Standards (CAS) provide the requirements for distinguishing direct and indirect costs and the development of indirect rates.

FAR 2.101 Defines indirect cost rate as: “the percentage or dollar factor that expresses the ratio of indirect expense incurred in a given period to direct labor cost, manufacturing cost, or another appropriate base for the same period.”

If you were told by a contracting officer to submit your indirect rates, and you looked up the definition in FAR, you might be even more confused!

While the CAS and the FAR are similar concerning to the conceptual basis, the CAS provides more definitive guidance for direct cost and indirect cost structures.

CAS 418 requires the consistent classification of costs as direct or indirect, establishes criteria for accumulating indirect costs in indirect cost pools, and provides guidance on allocating indirect cost pools.

The CAS fundamental requirements provide that:

  • A business unit shall have a written statement of accounting policies and practices for classifying costs as direct or indirect which shall be consistently applied;
  • Indirect costs shall be accumulated in indirect cost pools which are homogeneous; and
  • Pooled costs shall be allocated to cost objectives in reasonable proportion to the beneficial or causal relationships of the pooled costs to cost objectives.

Direct cost means “any cost which is identified specifically with a particular final cost objective.”

What are direct and indirect costs?

The FAR 2.101 definition of direct and indirect cost are as follows:

  • An Indirect cost is “any cost not directly identified with a single final cost objective, but identified with two or more final cost objectives or with at least one intermediate cost objective.”
  • A direct cost is “any cost that is identified specifically with a particular final cost objective. Direct costs are not limited to items that are incorporated in the end product as material or labor. Costs identified specifically with a contract are direct costs of that contract. All costs identified specifically with other final cost objectives of the contractor are direct costs of those cost objectives.”

In both the FAR and CAS regulations, the essential difference between direct costs and indirect costs is that only direct costs can be traced to specific cost objects. A cost object is something for which a cost is compiled, such as a product, service, customer, project, or activity.

Certainly, direct costs are more easily defined and identified in a contractor’s cost accounting system. However, the term “indirect cost” covers multiple cost categories, and the costs involved are not all incurred for the same reasons. The number of indirect cost accounts in a single company can vary, and the indirect structure needs to be tailored to your company and how it operates. For instance, some larger companies may have multiple indirect cost pools, while most small companies have only three categories. For most small businesses, indirect cost accounts fall into three main categories: Fringe Benefits, Overhead, and General and Administrative (G&A).

In addition to determining the categories for collecting indirect cost, the contractor must also establish an appropriate allocation base for each indirect cost pool so they may develop an indirect cost rate.

Navigating indirect rate structure

Understanding indirect rate structures doesn’t have to be confusing. Your CRI government contracting professionals are ready to help you learn how to develop your indirect rates, including what costs are included in the indirect cost pools and allocation bases.