Guide · Indirect Rates
How to calculate indirect rates for a small business
Pools, bases, and a worked example with real numbers for a ten-person company. What goes in each pool, what gets excluded before you divide, and how the same costs produce very different rates depending on choices you make once.
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The short answer
An indirect rate is a fraction. The pool is cost you cannot assign to one contract. The base is the activity that caused it. Divide one by the other and you have a rate you can apply to a contract.
Most small contractors need three: fringe, overhead and G&A. The arithmetic is simple. The judgment is in deciding what belongs in each pool, what base each is divided by, and what has to come out before you divide at all.
Those decisions are made once and then applied consistently for the year. Changing them mid-year, or applying them differently to different contracts, is what turns a rate question into an audit finding.
Structure
The three rates
| Rate | Pool contains | Divided by |
|---|---|---|
| Fringe | Payroll taxes, health insurance, retirement match, paid time off, workers’ compensation | Total labor dollars, direct and indirect |
| Overhead | Cost of running the production or engineering operation: supervision, non-billable technical time, facilities and tools used to perform the work | Direct labor plus fringe on direct labor |
| G&A | Cost of running the company: executive salaries, accounting and legal, business insurance, bank fees, corporate facilities | Total cost input, or value added |
Small companies with one line of business often run a single overhead pool. Companies doing both on-site and off-site work usually split it, because the cost of supporting someone at a customer facility is genuinely different. More pools mean more accuracy and more bookkeeping; the right number is the smallest one that reflects how the business actually works.
Numbers
A worked example
A ten-person engineering firm. Six people charge contracts directly, four are overhead and administration. Annual figures, simplified so the arithmetic is visible.
Step 1. Separate the labor
| Labor | Amount |
|---|---|
| Direct labor (6 engineers on contracts) | $720,000 |
| Overhead labor (engineering manager, lab tech) | $180,000 |
| G&A labor (CEO, office manager) | $200,000 |
| Total labor | $1,100,000 |
Step 2. Fringe
Fringe pool is $264,000: payroll taxes, health insurance, retirement match and paid time off for everyone. The base is total labor, because everyone receives those benefits.
$264,000 ÷ $1,100,000 = 24% fringe rate
Step 3. Overhead
Overhead pool is overhead labor of $180,000, plus fringe on that labor of $43,200, plus $90,000 of facilities, equipment and software used to perform the work. Pool is $313,200.
The base is direct labor plus fringe on direct labor: $720,000 + $172,800 = $892,800.
$313,200 ÷ $892,800 = 35.1% overhead rate
Step 4. G&A
G&A pool is G&A labor of $200,000, plus fringe on it of $48,000, plus $85,000 of accounting, legal, insurance and corporate costs. Pool is $333,000.
Using total cost input, the base is everything else the company spent: direct labor, fringe, overhead and other direct costs of $150,000, which comes to $1,356,000.
$333,000 ÷ $1,356,000 = 24.6% G&A rate
Step 5. What a contract dollar actually costs
| Line | Calculation | Amount |
|---|---|---|
| Direct labor | One hour of engineering | $100.00 |
| Fringe | 24% of direct labor | $24.00 |
| Overhead | 35.1% of labor plus fringe | $43.52 |
| Subtotal | $167.52 | |
| G&A | 24.6% of total cost input | $41.21 |
| Fully burdened cost | $208.73 |
A $100 hour costs $208.73 to deliver before any fee. If you have been pricing that hour at $150 because it felt like a reasonable markup, every hour sold loses roughly $59.
Judgment
The choices that move the number
Total cost input or value added for G&A
Total cost input divides G&A across everything, including materials and subcontracts. Value added excludes them. A company passing through large subcontracts gets a very different G&A rate under each, and the choice affects competitiveness on material-heavy bids. Pick the one that reflects how G&A effort is actually consumed, then stay with it.
Where a cost belongs
An engineering manager who also runs the company can be split, but the split needs a basis and it needs to be the same every month. Arbitrary reallocation between pools is one of the easier things for an auditor to spot and one of the harder things to defend.
One overhead pool or two
If some work happens at your facility and some at a customer site, a single pool charges on-site work for space it never used. Two pools are more accurate and more work. Below roughly ten people, one pool is usually right.
Unallowable cost in the pool
This is not a judgment call, it is a rule, and it is the most common error we see. Covered below.
Before you divide
What comes out before you divide
FAR Part 31 makes certain costs unallowable on government work. They are legitimate business expenses and you can spend money on them freely. They simply cannot be recovered from the government, directly or through a rate.
- Entertainment of any kind, including meals that are entertainment rather than travel
- Alcohol
- Interest on borrowed capital
- Lobbying and most political activity
- Bad debts
- Certain advertising and public relations
- Fines and penalties
- Contributions and donations
- Costs of defending certain proceedings
- Compensation above the statutory benchmark
These have to come out of the pool, before the rate is calculated, not off the invoice afterward. A pool containing unallowable cost produces a contaminated rate, and that rate goes on every voucher for every contract. One $12,000 entertainment account left in a $333,000 G&A pool overstates the rate by nearly a point, on everything, all year.
The practical fix is structural: give unallowable costs their own accounts in the chart of accounts so they are excluded automatically rather than remembered at year end. That is the single highest-return decision in setting up a DCAA compliant accounting system.
Timing
Provisional versus final
The rates above are calculated from a full year of actual cost. During the year you do not have that, so you bill at provisional rates, which are your best estimate, submitted and approved under FAR 42.704.
At year end the incurred cost submission recalculates the rates from what actually happened and the difference is settled. Bill below actual and you collect the shortfall later, often much later. Bill above and you repay.
Two practical rules. Base the provisional rate on a real forecast, not last year’s number, if anything material has changed. And revise it during the year when it becomes clear it is wrong, rather than carrying the error to settlement.
How we help
What this costs
Building an indirect rate structure starts at $3,000: pools and bases set up in your general ledger, unallowable accounts separated, the rates calculated and documented, and provisional billing rates prepared for submission. Published on the pricing page.
Keeping it current is part of our Cost-Type plan at $1,500 a month, which recalculates rates monthly and tracks provisional against actual so the year-end settlement is a formality rather than a surprise.
We reply to every inquiry within one business day.
Questions
Frequently asked
How do you calculate an indirect rate?
Divide the indirect cost pool by its allocation base. Fringe is the benefits pool divided by total labor. Overhead is the operations pool divided by direct labor plus fringe on direct labor. G&A is the corporate pool divided by total cost input or value added. Unallowable costs come out of the pool before you divide.
How many indirect rates does a small contractor need?
Usually three: fringe, overhead and G&A. Companies with both on-site and customer-site work often split overhead into two pools. Below about ten people a single overhead pool is normally right, because more pools mean more bookkeeping for accuracy you cannot use.
What is a normal overhead rate?
There is no normal. Rates depend entirely on how your costs are structured and which base you chose, so comparing yours to someone else’s tells you nothing. A 35 percent overhead rate at one company and 110 percent at another can describe identical businesses with different pool and base definitions. What matters is that yours is calculated consistently and can be explained.
What is the difference between total cost input and value added for G&A?
Total cost input allocates G&A over everything including materials and subcontracts. Value added excludes them, so G&A falls on labor-driven work only. A company passing through large subcontracts gets very different rates under each. Choose the one that reflects how G&A effort is actually consumed and apply it consistently.
Why do unallowable costs have to come out of the pool?
Because the pool drives the rate and the rate goes on every invoice. Removing an unallowable cost from one voucher does not fix the rate, so the error repeats on every contract all year. Giving unallowable costs their own accounts excludes them automatically.
Can we change our rate structure mid-year?
You can revise provisional billing rates during the year, and you should when they are clearly wrong. Changing the structure itself, meaning which costs sit in which pool or what base is used, is a different matter and needs a documented reason and consistent application going forward.
Do we need indirect rates on a firm-fixed-price contract?
Not for billing, since you invoice the price. You still need them to price work properly, and to know whether you are making money. A company bidding fixed price without knowing its burden is guessing.
More
Related services and guides
Provisional billing vs forward pricing vs final rates
Three indirect rates, three purposes. Which one bills, which one prices, which one settles, and what confusing them costs.
How much does DCAA compliant accounting cost?
Published numbers for the system build, the monthly work and the incurred cost submission, plus what moves the price.
Indirect cost rate structure
Pool and base design, provisional rates under FAR 42.704, and final rate settlement.
Guide: how to bill a cost-plus contract
What goes on the voucher, how indirect cost reaches the invoice, and why vouchers come back.
Guide: incurred cost submission
Due dates, the ICE model schedules, and what the adequacy review checks before the audit starts.
DCAA compliant accounting system setup
Chart of accounts, job cost, timekeeping and rate structure, built in your own QuickBooks.
Alexander Mungov, CPA
Founder and principal, M2 CPA
Alexander Mungov spent twelve years at the Defense Contract Audit Agency, in the Denver, European and Afghanistan branch offices, finishing as a Supervisory Auditor leading a team of six. He then built and ran the FAR, DFARS and CAS compliance program inside a defense technology company, as the primary liaison with DCAA and DCMA.
He founded M2 CPA to give small and mid-size contractors the compliance support that large primes take for granted. More about Alex.
Sources: FAR Part 31 (contract cost principles, including the expressly unallowable costs at FAR 31.205), FAR 42.704 (billing rates), FAR 42.705 (final indirect cost rates). The worked example is illustrative and does not reflect any client’s figures. Rates depend entirely on your own pool and base definitions. This guide is general information, not advice on a specific contract.
Not sure your rates would survive a look?
Send us your trial balance and your labor split. We will tell you whether the pools and bases hold up, and what a defensible structure would look like.