Why Budgeting is Important in Pricing and Provisional Indirect Rate Development

By Robert Smith, CEO of ICAT Systems
Updated October 31, 2024

A well-managed budgeting process is essential for business in general. It is particularly important for government contractors.

In developing an annual budget, government contractors should focus attention on budgeting their indirect rates to use for pricing work and for provisional billing rates in the new year.

Government contractors have several objectives with respect to their budget development process:

The Competitive Advantage of a Strong Budget

To set your business up for success in 2025, you need a plan. A thoughtful financial planning process enables you to take stock of the business, understand the indirect costs you expect to incur in the year ahead, and strategize different scenarios.

Throughout the budget process, management must make reasonable assumptions regarding the volume of business to be performed – taking into account the current backlog of work and potential new business. You will want to anticipate changes, consider facilities needs, assess the rising costs of items such as salaries and health care benefits, and account for inflation. Are you adding to your BD team or making technology investments? Add it to your budget.

For government contractors, this exercise yields a vital financial blueprint for managing existing contracts and making strategic decisions for growth. 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

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
• Bonuses
• Employee benefits
• 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. By distinguishing direct from indirect personnel costs, management will be able to calculate provisional indirect rates at the end of the budgeting process. 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 of direct labor should carry through from the budgeting of personnel costs. Typical direct cost elements other than labor will include subcontract costs, material costs, travel costs, and other direct costs.

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.

It is 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 opt for less detailed estimates. The same may hold true for the other cost elements. A contractor may 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

When adding indirect costs to your budget, one of three methods will typically be used:

• Escalation Percentage: Increase base year actual amounts by a percentage.
• Fixed Amount: Enter a dollar value when costs are fixed or escalation does not apply.
• Detailed Budget: Build out line items and assumptions for individual cost elements to capture greater detail.

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 some accounts, this escalation method does not apply, or provides an unreasonable result. Management can address these budget line items with more attention to achieve greater precision.

Building Indirect Rates into Contract Pricing

Contract pricing is all about recovering costs and generating fee. Contracts must be priced so that funding will recover the direct costs of performing the contract, as well as the indirect costs to be allocated to the contract, and if all goes according to plan, make a profit.

Indirect rates, with respect to pricing, are metrics used to estimate the indirect costs that will be allocated to the contract during the period of performance. These estimated indirect rates are applied to proposed direct costs so that contract pricing will sufficiently recover the proposed contract’s share of the contractor’s indirect cost burden.

The budget process quantifies the indirect costs to be recovered in the budget period. This provides contractors a source for supporting data to substantiate cost proposals.

A well-managed budgeting function also provides a pricing analysis tool for new contracts. By calculating the provisional indirect rates for the current workload, 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 indirect rates. Equipped with this information, management can make more competitive pricing decisions in its proposals for new work.

Historical Indirect Rates vs. Prospective Indirect Rates

It is important to note the distinction between historical indirect rates and prospective indirect rates.

Historical indirect rates measure activity that has already occurred. They are calculated based on accounting data that has been recorded in the contractor’s books.

Prospective indirect rates are estimates based on future activity — what you anticipate for 2025. They are calculated based on budgeting future business projections.

Contractors should use prospective indirect rates, rather than historical indirect rates, for contract pricing.

Prospective indirect rates enable contractors to establish pricing at a level that will enable recovery of costs expected during the period of performance of the contract — not what costs were in the past.

Because prospective indirect rates are used in contract pricing, unanticipated events can easily occur and have a significant effect on a contractor’s indirect rates and bottom line. Monitoring and managing the budget throughout the year can help mitigate against this.

Should circumstances change halfway through the year, a revised budget can quantify known changes to costs. With a current, detailed budget, a contractor is better equipped to calculate more precise prospective indirect rates for pricing future work.

How Software Can Help with Budgeting

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 development tool 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.