There are several different ways that the government can administer and compensate for services rendered or goods sold. The various methods can be cost reimbursable or based on a fixed price agreement where they could be per unit. The Federal Acquisition Regulation (FAR) Part 16 explains the various types of contracts in detail, summarized below are a few of the most common types.
- Firm fixed price
- Time and material contracts
- Cost-plus fixed fee
Regardless of the type of contract, it’s going to be important to understand how indirect rates work. I’ll touch briefly on that before I get deep into how each contract works.
Indirect Rates
If you’ve googled anything about government contracting, you’ve probably come across the term indirect rates. Indirect rates are used as a method to determine which proportion of indirect costs each program should bear. In other words, the costs a company is incurring that are not directly billable to the customer, but instead supports the company or results from the operations of the direct contract performance. These are costs that can be allocated to a final or intermediate cost objective and it can be used as a measure of performance for the company and an indicator of cost build up for bidding on contracts. Indirect rates apply to various contracting requirements for provisional rates, forward rates, billing, and incurred cost submissions that will need to be planned for and executed throughout the contracting process. Certain contract types require this work to be performed while others simply offer a benefit to the company’s financial performance. I’ll get into the why on that in just a few seconds.
Indirect rates are those costs that are resulting from performing on the contracts. If you look at an instance of direct labor – I have an employee who works 40 hours a week on a contract, there are other costs that aren’t just the labor portion that are incurred to the company that are on behalf of the work performed to the federal government. On that labor, there are also fringe benefits, meaning that there are certain costs that arise from the employment of those individuals (ex. PTO, 401k, payroll tax, etc.). If you look at certain other rates, there are certain costs for subcontractors and occasionally an administrative burden involved. The indirect rates are set up to determine the cost associated with that direct labor piece that could be billed back to the federal government. It would be prudent to understand the basics of indirect rates, regardless of contract type.
Firm Fixed Price
Firm fixed contracts include a negotiated contract price that we build either over time or at a point in time, and does not change regardless of the input of time or resources. While these contracts are not based on inputs, understanding the fundamental structure of indirect rates and budgeting will allow the company to bid a price that is competitive yet profitable to the company. Oftentimes, winning a contract without understanding the true cost of performance can lead to an undesirable outcome. So, you could bid a contract to where you know what the direct labor is going to cost you. You have a calculation for that, and you bid it at a lower margin.
The issue with this is that there are all sorts of costs that result from the employment of individuals and the performance of the contract in terms of fringe benefits, overhead, G&A, and sometimes a manufacturing and sub handling rate. Not understanding how these costs are included with direct labor could result in a poor performance, even though your margins are looking good. It’s important to understand what goes into all the costs of the simple direct labor to be able to bid a contract accurately.
Another common issue with firm fixed price is that, while typically most easy to administer, there is a risk that the company could lose out on their end. This is a type of contract where the company bears the risk, similar to a construction contract. You’re given a certain price to operate in and if you go over budget, the risk is on the company. That can be favorable from an administrative standpoint, but it also can be a risk from an operational standpoint.
Time and Material Contracts
Time and material contracts are those that are reimbursed for services rendered and materials based on a negotiated hourly rate. Another reason to understand why indirect rates are so important is because you want to make sure that your bill rates are reflective of all the costs you’re incurring, direct and indirect, so that they result in a profit for your company. A lot of times companies will just look at the gross margin on time and material contracts and think it’s performing well, only to realize that the actual hourly cost with indirect rates applied to that direct labor is more expensive than they anticipated. It’s essential to understand this in the bidding process so you can structure an agreed upon bill rate that will ensure the profitability of the company.
Cost-Plus Fixed Fee
The last and relatively most common and industry-specific to government contracting is cost-plus fixed fee. These are cost reimbursement type contracts which companies are compensated for the direct costs required to complete a job plus the allocable portion of indirect costs. Then there’s also an agreed upon fee percentage that’s applied, typically ranging from four to ten percent, which is your true profit on the job. Due to the nature of these cost reimbursement type contracts, there are several requirements to ensure fair and accurate reporting of indirect costs, including provisional rates, annual incurred cost submission, contract close out processes, among others. Because billings are prepared and submitted using a provisional rate, there’s a yearly true up required that is reported through the incurred costs submission. These are also subject to audit to ensure that the information is being recorded accurately. If your team is set up with the expertise to support a cost-plus contract, understanding how it works from the start really is a benefit to the company because, although it can be difficult to administer, you’re being reimbursed effectively for all your direct costs and the applicable indirect costs.
It’s worth noting that there is a risk with some unallowable costs if you don’t manage those costs properly. These are costs that the federal government says may be indirect costs, but we don’t see those as something that should be reimbursed because they’re not technically supporting the actual contract or the individuals working on the contract. If you can manage your unallowable costs, in theory, there should be a pretty good return on all cost-plus contracts, which certainly benefits the company to understand how that works and to be working on those contracts.
Where we see the greatest success is when companies build a team with experience and partner with reputable firms and service providers so that they can set a foundation to succeed in the long run. The goal here is that you get onto a contract and you know how to administer it from the start, you know how to account for it, you know how to plan for it and budget it. Securing the proper resources will position you to take advantage of some of the benefits we talked about while minimizing setbacks. Investing in the company allows the CFO/CEO to focus on what’s upcoming and go after those contracts instead of looking in the rearview. We find that sometimes if some of these imperative functions aren’t invested in soon enough, you can spend some time trying to clean up the past, which we like to help people avoid.
There is a plethora of information that needs to be considered when contemplating working with the federal government. Recognizing that benefits, knowing what to consider, and how to go through the process is a huge part of succeeding in the industry. While these answers represent the most common contract types and basic considerations, we would be happy to field any additional questions or further explanations on the information above to help you work through the process of becoming and succeeding as a government contractor.
Next Up: GovCon FAQ #6: How can I prepare to bid on an RFP that mentions an “approved accounting system”?
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