Your Indirect Rate Structure Is Either Your Best Defense or Your Biggest Liability
If you work in or around government contracting long enough, you learn to spot the organizations that are audit-ready and the ones that just think they are. The difference rarely shows up in the financials. It shows up in the indirect rate structure.
It's the first thing I pull in any new GOVCON engagement. Not because indirect rates are the most important line item on the page, but because how they're set up tells me almost everything about the financial maturity of the organization. A well-constructed indirect rate structure signals that someone intentionally built the cost accounting system. A murky one signals that someone once made a decision under pressure and nobody has touched it since.
Most organizations are somewhere in the second category. And most of them don't know it until a DCAA auditor is sitting across the table.
What an indirect rate structure actually is
For anyone new to cost-type government contracting, indirect costs are the costs of running your organization that can't be tied directly to a single contract. Think fringe benefits, overhead, and general and administrative expenses. Because these costs support the work across all your contracts, you have to allocate them proportionally using a rate.1
The rate itself is a ratio: your indirect cost pool divided by your allocation base. Fringe benefits divided by direct labor. Overhead divided by direct labor. G&A divided by total cost input. These ratios get applied to your contracts to recover the costs of doing business.
That's the simple version. The complexity is in whether the pools are defined correctly, whether the bases are appropriate, and whether the structure holds up under scrutiny. DCAA's job is to determine whether your accounting system is adequate and whether your costs are allowable, allocable, and reasonable under FAR Part 31.2 An indirect rate structure that can't answer those three questions is a liability, whether or not anyone has formally challenged it yet.
What I actually find when I look
The most common problem isn't fraud. It's drift.
A CPA or consultant set up the rate structure when the organization first won a cost-type contract. It made sense at the time. Then the organization grew, added contracts, changed headcount, and shifted the mix of work. Nobody revisited the structure because nobody had a specific reason to, and the rates kept flowing through the system on autopilot.
A few years pass. Now you have pools that don't reflect how costs actually accumulate. Allocation bases that made sense for a 20-person shop but create distortions at 80 people. Costs are sitting in the wrong bucket because the original logic got stretched to cover situations it wasn't designed for.
When I ask the finance team to walk me through it, I'm listening for two things. First, can they explain the structure without referencing what the previous person told them? Second, does the explanation hold up when I push on the edges?
Hearing "this is the way we've always done it" tells me what I need to know. It's not a malicious answer. It's an honest one. But it's also the answer that will not satisfy a DCAA auditor, and it usually means there's a buried cost somewhere in the structure that nobody has quantified.
Where the money goes
Indirect rate problems show up in two directions, and both cost you.
The first is overloading the indirect cost base. If your pools include costs that shouldn't be there — costs that are directly attributable to a specific contract or aren't allowable under FAR Part 31 — you're inflating your rates.3 That inflation may get through on current contracts, but it creates audit risk on incurred cost submissions and can result in disallowed costs, penalty findings, and repayment obligations that are significantly more expensive than the original savings.
The second is leaving money on the table. If your pools are underloaded, or if your base is too broad, you're recovering less than you're entitled to on cost-plus and T&M contracts. This is more common than most organizations realize. A fringe benefit pool that doesn't capture all allowable benefits, or a G&A base that dilutes the rate by including too many direct costs, quietly erodes margin on every cost-reimbursable contract you have.
Neither of these problems announces itself. The rate just keeps running, the invoices keep going out, and the gap accumulates until something forces a look. That something is usually an audit.
The two-hour assessment
A first-pass review of an indirect rate structure takes roughly two hours if the documentation exists. I'm looking at the cost accounting policies, the pool definitions, the base allocations, the prior-year actuals versus provisional rates, and the incurred cost submission history, if there is one.4
What I'm trying to establish is whether the structure is internally consistent, whether the pools and bases are defensible under FAR Part 31, and whether the organization could walk a DCAA auditor through the logic without referring to notes.
Two hours. That review has, in more than one engagement, surfaced structural problems that had been accumulating for years. The cost of fixing them before an audit is a fraction of the cost of remediation afterward.
The question worth asking now
If you're a government contractor operating under cost-type or T&M contracts and you're not certain when your indirect rate structure was last formally reviewed, that's the question to start with.
Not "are we audit-ready?" That question is too broad to answer usefully. Start with the rate structure. Ask your finance team to walk you through the pool definitions and the allocation bases. Ask when the structure was last revisited relative to your current size and contract mix. Ask whether your provisional rates for this year are based on a real projection or last year's actuals carried forward.5
The answers will tell you more about your audit readiness than any checklist will.
If you want a second set of eyes on what you find, I'm at atisha.burks@anchorpointrising.com.
Notes
1 Indirect cost allocation requirements for federal contractors are governed by FAR Subpart 31.2 — Contracts with Commercial
Organizations. FAR 31.201-4 defines allocability: a cost is allocable if it is assignable or chargeable to one or more cost objectives on
the basis of relative benefits received or other equitable relationship. Federal Acquisition Regulation, 48 C.F.R. § 31.201-4.
2 DCAA's authority to audit contractor accounting systems derives from 10 U.S.C. § 3841 and is exercised through the DCAA
Contract Audit Manual (CAM), Chapter 6, which covers the audit of indirect costs. An adequate accounting system must meet the
criteria in SF-1408, Pre-Award Survey of Prospective Contractor Accounting System. Defense Contract Audit Agency, CAM 6-100.
3 Unallowable costs must be identified and excluded from any billing, claim, or proposal under FAR 31.201-6. Common unallowable
costs include entertainment, certain lobbying expenses, and costs related to interest on borrowings. Misallocation of unallowable
costs into indirect pools is among the most frequently cited findings in DCAA audits of incurred cost submissions. FAR 31.201-6;
DCAA CAM 6-600.
4 Contractors operating under cost-reimbursement contracts are required to submit an annual incurred cost proposal (also called the
Incurred Cost Electronically submission, or ICE) within six months of the close of each fiscal year. DCAA uses this submission to
audit actual indirect rates against the provisional rates billed during the year. Variances can result in billing adjustments in either
direction. DCAA CAM 6-700; FAR 52.216-7.
5 Provisional billing rates are established at the start of a fiscal year as an estimate of what indirect rates will be when actuals are
reconciled. If provisional rates are based on stale data — prior-year actuals without adjustment for current-year cost structure
changes — they may create significant variance at year-end settlement. FAR 42.704 governs the establishment and revision of
provisional rates.
