FAR 31 Compliant Indirect Cost Rate

One of the audits I do and have traveled for are audits of indirect cost rates, in compliance with Federal Acquisition Regulations Section 31 (aka FAR 31). Government contractors who charge the government for indirect costs may only include costs which are reasonable, customary, allowable, and supported. Sometimes we are hired directly by the contractor to perform the audit, other time we are contracted by a government agency to do it.

An indirect cost is any cost that is not directly identifiable with a cost objective, or contract. Think of costs such as utilities, admin, rent, office supplies, etc. The indirect cost rate is calculated by dividing the indirect costs (numerator) by an appropriate cost driver (denominator). Commonly, this is direct labor; depending on the contractor and costs, this may include other direct costs, and other types of costs. In a simple calculation, indirect costs divided by direct labor equals the indirect cost rate.

What is a FAR 31 compliant indirect cost rate? Big picture – the government (i.e. taxpayers) don’t want to pay for costs such as excessive executive compensation, parties, alcohol, marketing (i.e. business expansion), and expects the contractor to be able to support costs with proper documentation. Executive compensation includes base salary, bonuses, deferred compensation etc – the compensation package. Executive compensation maximum is set by the federal government and is evaluated/increased annually.

The contractor’s accounting system should allow for the proper tracking of allowable costs. In the normal course of business, most contractors will incur costs that are unallowable under FAR 31. For example, it is common for companies to have a holiday party; this is great for employee morale, but not an allowable cost under FAR 31. It is common for companies to incur marketing costs; while this is good for business expansion, it is not allowable under FAR 31. Employees may purchase alcoholic drinks while traveling for business and get reimbursed; while this is not an unreasonable expense, it isn’t allowable under FAR 31.

After the fiscal year end, the contractor puts together their schedule of indirect costs. The better the accounting system tracks costs, the easier this will be to compile, and, potentially, the fewer the audit adjustments. While an audit adjustment isn’t a terrible thing, too many indicate an internal control weakness.

For our audit of indirect costs, we review the schedule for included costs, then select a sample to ensure those costs are allowable under FAR and properly supported. When a cost lacks support, this is a tough adjustment to make and difficult for contractors to identify and remove because, while the cost may, in fact, be allowable, if there is no support (receipt, invoice, contract, agreement, etc) it isn’t allowed to be included in the rate. Therefore, it must be removed.

All the above may sound boring and uninteresting, but my favorite part of these audits is the people part of it. I love getting out of the office, out of the city, the state, and meeting new people, engaging in conversation. Numbers are just numbers – cold, unfeeling. But the people behind the numbers are what is interesting. I enjoy having light conversation with my clients/contractors, and learning more about the city/state in which they live through dining or things-to-do recommendations. While maybe the title “auditor” may not have the most positive connotation behind it, I like to think I represent my profession positively.