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Calculating a Reasonable and Proper Overhead Rate

Professional engineering, architectural, utility and railroad companies who perform work for governmental agencies are often required to have an independently audited overhead rate.  The overhead rate is calculated by dividing total allowable indirect expenses over total allowable direct labor, however getting to that simple step takes some effort.

The numerical inputs to the overhead rate calculation are subject to the Federal Acquisition Regulations (“FAR”) 48 CFR, Chapter 1, Part 31, Contract Cost Principles and Procedures, which is effectively a set of principles guiding those costs that can and cannot be included in a Company’s overhead rate. The FAR is updated annually, however revisions are typically more frequent (www.acquisition.gov). Further, the American Association of State Highway and Transportation Officials (“AASHTO”) Uniform Audit & Accounting Guide was issued to assist engineering consultants, independent CPA’s, and state Department of Transportation (“DOT”) auditors with the preparation and auditing of the Schedule of Overhead / Indirect Costs and Rate Calculation (“Schedule”). The Schedule must be audited in accordance with generally accepted government auditing standards (“GAGAS”).

Generally, the allowability of costs is determined by reasonableness, allocability, and terms of the contract. Just to take that a step further, there are some common costs that are specifically unallowable, such as:

  • Alcoholic beverages;
  • Bad debts;
  • Contributions or donations (exceptions apply);
  • Costs incurred in connection with, or related to, the mischarging of costs on Government contracts
  • Costs of fines and penalties (exceptions apply);
  • Entertainment costs;
  • Goodwill;
  • Interest on borrowings, bond discounts, costs of financing and refinancing capital, legal and professional fees paid in connection with preparing prospectuses, and costs of preparing and issuing stock rights;
  • Losses on other contracts;
  • Organizational costs

There are also several expenses that require a detailed review, as they are often partially unallowable. The most common of these expenses for affected companies is compensation. FAR 31.205-6 should be reviewed closely and the National Compensation Matrix must be used to determine reasonable levels of executive compensation for engineering consultants.

In addition, the costs of idle facilities, such as maintenance, repair, housing, rent, and other related costs; e.g. property taxes, insurance, and depreciation, are also partially unallowable. Costs and credits related to employee morale, health, welfare, food service, and dormitory are generally allowable, subject to stipulations. Costs incurred in maintaining satisfactory relations between the contractor and its employees are allowable. However, some labor relations costs such as collective bargaining are unallowable. Certain relocation costs for permanent employees are allowable if numerous requirements are met.

Independent research and development and bid and proposal costs are allowable as indirect expenses. Research and development sponsored by a grant or required in performing a contract are allowable to the extent they are within the limits of the contract or grant; excess research and development costs are unallowable. Most legal expenses are allowable. However, if legal expenses were incurred to refute the U.S. government, then they are unallowable.

At the end of the day, a working knowledge of FAR 31.205 is essential to preparing and submitting an overhead rate calculation, specifically due to the nuances of how many costs are specifically unallowable or partially unallowable, but there can be a few phases to readiness.  For companies pursuing contracts with governmental agencies, it is critical to consult with properly trained professionals to help bring this knowledge in house.  For companies that are already party to applicable contracts, the knowledge should be in-house and financial management should have experts available for consultation as needed. Finally, companies should be diligent in selecting auditors familiar with the appropriate standards and whose file documentation will stand up to examination by governmental authorities.  This is an often overlooked, but critical step in having your overhead rate accepted by the contracting body.

While the compliance can be intimidating, with proper planning and appropriate education, any company can effectively calculate a reasonable and proper overhead rate that will be accepted by contracting agencies.

Author: Christina Lazaro, CPA, PSA | clazaro@withum.com
T (732) 759 6839

For questions or more information on this topic, contact a member of Withum’s Professional Services Team by filling out the form below.

To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

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