Why Budgeting is Important in Pricing and Provisional Indirect Rate Development
By Robert Smith, CEO of ICAT Systems
Updated for 2018. Originally published 2016.
As we approach the end of the year, well-managed government contractors are turning their attention to budgeting for 2019. A well-managed budgeting process is essential for business in general, and it is particularly important for government contractors. Contractors have several objectives with respect to their budget development process:
- Establish a financial blueprint for how they expect 2019 to operate;
- Establish a basis for planning the recovery of indirect costs through contract pricing; and,
- Establish budgetary support for their provisional indirect rate proposal.
Budgeting for Government Contracts
There are three general areas of costs that must be addressed in the budget process:
1. Personnel Costs
Personnel costs include base compensation and bonuses, employee benefits, and payroll taxes. Contractors should calculate these costs for existing personnel, existing vacant positions, and any new positions anticipated for the budget period. When projecting personnel costs, management must consider any adjustments to the compensation of individual employees during the budget period. Management must also make reasonable assumptions regarding increases in the costs associated with employee benefits programs and changes in employment tax bases and rates.
It is also essential for management to properly classify compensation costs to the proper direct and indirect cost pools, so that at the end of the budgeting process management will be able to calculate provisional indirect rates. When it is practical to do so, it is desirable for management to budget direct labor to individual projects.
2. Direct Costs other than Personnel
Budgeting direct costs other than direct labor is largely done on a project-by-project basis. However, some contractors perform a multitude of small, short-term jobs, and in such cases, management may prefer to budget costs based on estimating the volume of such jobs to be performed during the year. Budgeting of direct labor should carry through from the budgeting of personnel costs. Typical cost elements other than labor will include subcontract costs, material costs, travel costs, and other direct costs.
It is certainly up to management to determine the level of detail to be included in the budget. Some contractors may want to schedule out specific bills of materials in great detail, while others may choose to make less detailed estimates. The same may hold true for the other cost elements. A contractor may decide to schedule out the detailed cost provisions of subcontracts and consultant costs if it is reasonable to budget that level of granularity on projects. Such detailed planning and budgeting provides for more effective management of projects.
3. Indirect Costs other than Personnel
Budgeting of indirect costs other than labor is typically done by applying an escalation factor to a base period balance for the individual accounts contained in the indirect cost pools. Management can then evaluate the budgeted amounts for these accounts to determine whether this method produces a reasonable result. For any accounts where this escalation method provides an unreasonable result, management can then address the budget with more attention.
The Competitive Advantage of a Strong Budget
Throughout the budget process, management must make reasonable assumptions regarding the volume of business to be performed, expansion of facilities, as well as the rising costs of items such as rents, health care benefits, and general inflation.
Once a budget is produced, management will have a tool to:
- Quantify the indirect costs that must be recovered with contract revenues during the budget period
- Evaluate the sufficiency of the Company’s existing backlog of work
- Make estimates for new work that will be awarded
- Develop and submit a Provisional Indirect Rate Proposal
Provisional Indirect Rates
DCAA has published a guide for submitting a Provisional Indirect Rate Proposal, available on the DCAA website. An essential component of a Provisional Indirect Rate Proposal is a schedule of the indirect cost pool and allocation base elements for each indirect cost pool. The budget provides the information needed to generate these schedules.
With respect to contract pricing, companies generally use provisional indirect rates to price contract costs in proposals for new work. A well-managed budgeting function provides a pricing analysis tool for new contracts. By calculating the provisional indirect rates without including assumptions for new work, and then recalculating indirect rates taking into account specific cost proposal data, contractors can see the impact that winning new work will have on the budgeted indirect rates. This pricing analysis exercise enables management to quantify the impact that winning a particular award will have on the indirect rates. Equipped with this information, management can make more competitive pricing decisions in its proposals for new work.
How Software Can Help
The Budget process can be cumbersome, however the benefits to contract management, indirect rate monitoring and accurate pricing, and thus to the company’s bottom line, are significant.
Cost accounting software with a budgeting function can help streamline the process. When designed for government contractors, it should enable contractors to classify costs by direct and indirect cost pools, factor in costs for new personnel, calculate Provisional Indirect Rates from budgeted costs, and toggle in/out cost proposal data to assess the impact of new work on indirect rates.
ICAT’s budget function was designed to give government contractors a flexible framework for granular budget development and determining provisional indirect rates. ICAT enhances QuickBooks® with these budget capabilities for government contractors.