ARTICLE | October 28th, 2026

Indirect cost rates influence what federal contractors and engineering firms propose, bill and ultimately earn. Rising rates do not necessarily mean rising spending. Our recommendation: review the cost pool, allocation base and business assumptions together, rather than carrying last year’s percentages into next year’s work.

At Larson Gross, we view indirect rates as a management issue, not simply a year-end calculation. The most useful question is not, “Is our rate competitive?” It is, “Does this rate reflect the work we actually expect to perform?” For many architect-engineer procurements, selection is qualifications-based and price is then negotiated for fairness and reasonableness. That makes “Is our rate competitive?” even less useful than “Is our rate supportable for this work?”

Start with the costs behind the percentage

Direct costs can be identified with a particular contract. Indirect costs support multiple contracts or activities and are grouped into pools, then allocated using a base. The basic calculation is:

Indirect cost pool ÷ allocation base = indirect rate.

Common pools include fringe, covering employee-related costs such as benefits and payroll taxes; overhead, supporting an operating function or department; and general and administrative expenses (G&A), supporting the business overall. Their composition and allocation bases depend on the contractor’s operations.

The percentage is the result. Understanding which costs belong in the pool and which activities should absorb them comes first.

A higher rate does not always mean higher spending

Consider this hypothetical change:

Overhead stayed flat. The rate increased because direct employee labor declined as more work moved to subcontractors or specialty subconsultants. Fewer labor dollars now absorb the same shared costs.

Our recommendation: Investigate the pool and base separately. Cutting overhead and rebuilding the labor forecast address different problems. A rate change should start a business conversation, not trigger an automatic spending cut.

Revisit the structure when the business changes

More subcontracting, a new location or employees shifting among design offices, field assignments, and project sites may change which contracts benefit from shared costs. A headquarters-heavy overhead pool may no longer reasonably serve a growing field operation. FAR 31.203 recognizes that operational changes can require revised allocation methods or separate offsite cost groupings. Acquisition.gov

For engineering firms, rate pressure often comes from changes in chargeability, labor mix, nonbillable proposal effort, new technical disciplines, design technology, or a growing use of specialty subconsultants. The appropriate treatment depends on the facts and the firm’s consistently applied accounting practices, but these changes should trigger a fresh look at both the pool and the base.

Allocable also does not mean allowable. A cost may be assigned to a contract yet remain ineligible for Government reimbursement. Unallowable costs must be identified and excluded from applicable Government billings, claims and proposals. Acquisition.gov

However, costs that properly belong in an allocation base generally stay there and absorb indirect costs, even when unallowable. Removing them can improperly shift their share of indirect costs to other work. Acquisition.gov

Our recommendation: Document each pool’s contents, its allocation base and why that base reflects which contracts or activities benefit.

Price the work you expect to perform

For a bid with $500,000 of direct labor, a 30% overhead rate assigns $150,000 of overhead. At 40%, it assigns $200,000. That $50,000 difference comes before fringe, G&A or other indirect costs.

On firm-fixed-price work, underestimated costs can reduce profit without increasing the contract price. On cost-reimbursement work, recovery depends on allowable incurred costs, appropriate allocation and the contract’s terms. Acquisition.gov

Related Larson Gross construction guidance, featuring Caitlin Schiefelbein, reinforces the broader pricing principle: “Price the work with complete overhead visibility.” Larson Gross

Our recommendation: Use forecast pools and bases for the performance period, rather than automatically using last year’s rates. A familiar percentage is not necessarily a reliable pricing assumption.

Keep proposals, accounting and billing aligned

If a proposal treats project administration as indirect overhead, charging similar work directly after award can distort reported margins and raise consistency concerns. Costs incurred for the same purpose in like circumstances need consistent direct or indirect treatment. Acquisition.gov

Trace a recent proposal into the accounting records. Can your team explain the treatment of labor, project management, travel and shared software?

Billing rates need separate attention. On applicable contracts, they provide temporary reimbursement of indirect costs before final rates are established. FAR 42.704 allows revisions to help prevent substantial overpayment or underpayment. Acquisition.gov

Suppose you are billing overhead at 32%, but your current forecast points to 39%. The billing rate and expected cost experience are telling different stories.

Our recommendation: Distinguish what you are billing from what you expect the work to cost. Discuss whether a billing-rate revision is appropriate rather than assuming reimbursement will automatically catch up.

Make rate reviews part of running the business

We recommend starting with quarterly reviews, with more frequent updates during rapid growth, major contract turnover or significant staffing changes. Bring finance, proposal and operational leaders into the discussion.

Document significant differences and assign responsibility for follow-up. Focus on what the numbers require you to reconsider, not simply whether the spreadsheet calculates correctly.

Look beyond the spreadsheet

A mathematically correct rate can still rest on outdated assumptions. The goal is a rate structure you can explain, support and use to make better decisions.

Contact your Larson Gross advisor to review your indirect cost structure, forecasts and pricing assumptions before your next significant proposal or year-end review.

This article provides general information. Requirements depend on applicable regulations and contract terms; seek advice tailored to your circumstances.