Indirect Rate Essentials

2. Indirect Rate Essentials Breakout Session # 109 Presented by Craig Stetson and Noah Leiden July 19, 2010 Session Schedule: 11:15-12:30 1

3. Learning Objectives What are Indirect Rates? Why Indirect Rates are Important Regulatory and Other Guidance Indirect Rate Structures Designing your Company’s Rate Structure Indirect Rate Calculation Examples

4. What are Indirect Rates?

5. What are Indirect Rates? • Indirect rates are computed factors or percentages representing the ratio of selected indirect expenses to specific elements of cost or other performance metrics • Specific elements of cost used for calculation commonly include direct labor, subcontracts or a combination of various manufacturing activities; other performance metrics may include direct labor hours or units of output or production • Indirect rates are applied for purposes of achieving full cost recovery and equitable distribution of indirect expenses to cost objectives • Typical indirect rates are computed and associated with fringe benefits, overhead and general & administrative type activities

6. Indirect Costs • Not incurred for the benefit of a single objective or contract • Incurred to support the organization or business unit as a whole • Benefits two or more final cost objectives • Remainder of costs to be allocated after direct costs are identified and assigned to projects • Examples include • Depreciation on buildings and equipment • Occupancy and Facilities • Insurance, fringes, taxes, etc. • General management and administration (e.g., salaries and expenses of executive officers, human resources, legal accounting and finance, internal audit, ethics, etc.)

7. Direct Costs • Identified solely with a particular final cost objective • Benefits only one cost objective or contract and would not have been incurred but for the same cost objective or contract • Costs incurred for the same purpose, in like circumstances, must be consistently treated as direct only or indirect only – CAS 402 • Direct costs of minor amounts may be treated as indirect when consistently applied • Examples include • Labor performed specific to contract scope of work • Subcontracts under specific contracts • Material required to perform contract scope of work

8. Allowable Costs • Critical element in calculating indirect rates is exclusion of unallowable costs from applicable expense pools • Allowable costs are: • Reasonable and Allocable • In conformity with Cost Accounting Standards and Generally Accepted Accounting Principles • In accordance with contract terms • In compliance with FAR Part 31 Cost Principles • Unallowable costs commonly derived from statue, public policy or nature of activity • Directly associated costs • Potential for assessment of penalties due to inclusion of selected unallowable costs

9. Accounting for Unallowable Costs • Appropriately identify and exclude unallowable costs from cost representations (e.g., billings, claims, proposals, etc.) to the Government • Unallowable indirect costs must be excluded from applicable expense pools; unallowable directcosts, or other costs normally included in an allocation base, must remain in base when calculating indirect rates • Identification of unallowable costs may be achieved using various methods – original point of entry, statistical sampling, other analytical • Even though costs may be legitimate business expenses, they may nevertheless be unallowable for the government contracting purposes, e.g., interest

10. Key Terminology Allocation Base Measure of activity such as direct labor dollars used to calculate indirect expense rates and assign costs to cost objectives Direct costs Costs associated solely with a specific final cost objective Final cost objective Cost objective which has allocated to it both direct and indirect costs and is a final accumulation point in the accounting system – generally a contract Indirect costs Costs that cannot be identified to a particular final cost objective and that benefit more than one final cost objective Intermediate cost objective Cost objective, created for more accurate allocations, consisting of indirect costs that are ultimately allocated to final cost objectives Expense Pool Grouping of homogeneous costs identified with two or more cost objectives; numerator of rate calculation Indirect Rate Percentage result of dividing expense pool by allocation base Total cost input (TCI) All costs, less general & administrative expenses; a common allocation basis for G&A and used in related rate calculation

11. Why Indirect Rates are Important

12. Contract Pricing Actions, Close-Out and On-going Compliance • Flexibly Priced Contracts Including • Cost reimbursable contracts • Cost Type contract bids and incurred cost proposals • Time & Materials contracts • Where burdens are applied to the cost reimbursable (“Materials”) portion of contract • Buildup/creation of T&M hourly rates • Fixed Price contracts • When cost or pricing data is required during the proposal process • When there is an Incentive Fee component • Progress Payments based on Cost • Contracts subject to Cost Accounting Standards (CAS) • Contract Termination Settlement or Request for Equitable Adjustment Proposals • Internal Management Reporting, Budgeting and Resource Consumption

13. Contract Life Cycle • Forward Pricing Rates • Represents the best estimate of indirect cost rates at the time of submission; typically used to estimate pricing of multi-year procurements • Used to estimate indirect costs for future periods of Government contract work; typically agreed to with the government for a 3 to 5 year period • Provisional Billing Rates • Used for interim billing of costs; subject to true-up at year end • Established by Contracting Officer or Auditor based on contractor billing rates submission, recent evaluation of indirect rates or Forward Pricing Rates • Revised as necessary based on mutual agreement • Should be updated soon after year-end

14. Contract Life Cycle (cont.) • Final Indirect Rates • Due 6 months after year-end (Final Indirect Cost Rate Proposal) • Final billings for completed contracts are due within 120 days after settlement of rates • Quick-Closeout Procedures • Negotiated or audit-determined final rates used for • Billing updates (impact differences in provisional rates) • Contract close-out • Preparation of completion vouchers (due within 120 days after settlement of final indirect costs rates for contracts) • Determination of final incentive/award fees

15. Regulatory and Other Guidance

16. Regulatory and Other Guidance • Federal Acquisition Regulation (FAR) • Subpart 2.1 - Definitions • Part 31 – Contract Cost Principles and Procedures • Subpart 42.7 – Indirect Cost Rates • 52.216-7 – Allowable Cost and Payment Clause • Cost Accounting Standards (CAS) • CAS 401 - Consistency in Estimating, Accumulating and Reporting costs • CAS 402 - Consistency in Allocating costs Incurred for the same Purpose • CAS 403 - Allocation of Home Office Expenses • CAS 405 - Accounting for Unallowable Costs • CAS 406 - Cost Accounting Period • CAS 410 - Allocation of Business Unit G&A to Final Cost Objectives • CAS 418 - Allocation of Direct and Indirect Costs • OMB Circulars • OMB Circular A-87 – Cost Principles for State, Local and Indian Tribal Governments • OMB Circular A-122 – Cost Principles for Non-Profit Organizations

17. Indirect Rate Structures

18. Indirect Rate Structures • Calculation Indirect Rate = Indirect Cost Pool Allocation Base

19. Common Indirect Rate Structures • Fringe Benefits Rate (single or multiple rates permitted, depending on circumstances) • Overhead Rate (single or multiple rates permitted, depending on circumstances) • General and Administrative Rate (single G&A expense rate required at segment or business unit level)

20. Fringe Rate • Employee fringe benefit costs (e.g., payroll taxes, vacation, sick, retirement, health care, bonus, deferred compensation, insurance, etc.) • Calculation Fringe Rate =Fringe Pool Total Payroll Dollars • Fringe rate can be intermediate or final

21. Overhead Rate • Management or supervision of activities or cost of certain segments, divisions, business units, etc.,that benefit more than one project or contract, but not the business unit as a whole (e.g., division middle management, supervisors, project leadership benefiting multiple projects, site rent, etc.) • Generally costs that support performance of contract scope of work and would not be required but for award of the contract • Calculation Overhead Rate = Overhead Pool Loaded (or unloaded) Direct Labor Dollars

22. General & Administrative (G&A) Rate • Management and administration costs that benefit the business unit or company as a whole (e.g., executive management, accounting, finance, legal, etc.) • Costs for running the business and not necessarily supporting contract scope of work activities • Calculation G&A Rate = G&A Pool Total Cost Input • Other bases include value-added cost input; single element cost input

23. Other Indirect Rate Structures • On-site Overhead Rate (s) • Off-site Overhead Rate (s) • Subcontractor/Material Handling Rate (s) • Service Centers • Home Office Allocations

24. Designing Your Company’s Rate Structure

25. How to Create the Proper Rate Structure • Define and document operating structure • What products or services do you provide and who buys them? • What operating structure best aligns with delivery of products or services – single operating entity combined with a corporate function, separate business units under a single or intermediate home office? • What functional disciplines in the company exist and who do they support? • What are key resources consumed during typical contract performance cycle? • Are resources consumed proportionately across all contracts? • Define and document all costs as direct, indirect or both (CASB disclosure statement Part III for guidance) • Look at cost-benefit theme • Identify causal / beneficial relationships between indirect and direct costs • Identify cost drivers and appropriate allocation metrics • Accumulate indirect costs into logical and homogeneous groupings (pools) based upon causal beneficial relationships • Segregate unallowable costs and remove from expense pools

26. Indirect Rate Examples

27. Starting Point for Cost Pools – Trial Balance

28. Fringe Rate

29. IT Service Center

30. Overhead Rate

31. G&A Rate

32. Cost Build-Up “Proof”

33. Questions ?

34. About Baker Tilly Founded in 1931 as a certified public accounting firm Currently operate in six states with over 1,400 professionals Member of Baker Tilly International, the world’s 8th largest network of accounting firms Headquartered in Chicago East Region is located in Washington, D.C. with over 275 professionals East Region provides a range of professional services including: Financial statement audit Tax planning and compliance Consulting services to private and publicly traded companies across many industries Government contract and grant consulting Forensic and litigation services Mergers and acquisitions Technology management

35. Baker Tilly • Craig Stetson, Director • Craig has over 20 years of direct experience in government contract accounting, pricing, subcontract management, regulatory and federal contract compliance, business system implementation, and internal control oversight.  His client base has included aerospace and defense, manufacturing, construction, architecture and engineering, information and communications, higher education, and non-profits.  His experience includes, claims preparation and negotiation; cost allowability; application of Federal Acquisition Regulation (FAR) and OMB Circular requirements; program reviews related to internal control sufficiency and overall self governance, accounting and business systems assessment related to government contract compliance requirements; cost estimating, accounting and auditing of federal contracts and grants; and, application and interpretation of Cost Accounting Standards (CAS).  Prior to Baker Tilly, Craig worked for KPMG, Deloitte & Touché and DCAA.  Craig has a MBA from California State University and a BS in Accounting from Syracuse University. • Tel: (703) 923-8223, craig.stetson@bakertilly.com

36. Baker Tilly • Noah Leiden, Director • Noah has over 20 years of experience in government contract accounting, pricing, • business system and internal control oversight, and regulatory and federal contract compliance assisting defense, manufacturing, engineering, information and communications, higher education, and non-profit clients. Noah earned his Bachelor of Science in Accounting from Pennsylvania State University. He is a member of the American Institute of Certified Public Accountants, Greater Washington Society of Certified Public Accountants, Maryland Association of Certified Public Accountants, and National Contract Management Association. Prior Baker Tilly, Noah worked for DCAA, KPMG, BearingPoint, and Navigant Consulting. Noah is a member of the Consulting team in Washington D.C. • Tel: (703) 923-8321, noah.leiden@bakertilly.com