Indirect Rates for Federal Awards: What are They and Why Do I Need Them?
Getting Started With Indirect Rates for Federal Awards
Most organizations that apply for a federal award for the first time are overwhelmed by the process. From the required system registrations, hunting down forms, to preparing content that is responsive to the solicitation, to managing the application portal, it can feel like an infinite maze of complicated requirements with no end in sight. Often the last thing on an applicant’s mind is the strategy behind the indirect rates they use in their proposal’s budget. However, if you are awarded your proposed project, you will quickly learn how applying indirect rates can make or break a project in the execution stage.
What are indirect rates?
In the proposal budget, there are two types of costs: direct and indirect. Direct costs are budgeted explicitly on an exact dollar basis, while indirect costs are captured through a rate applied to the direct costs proposed.
Direct costs are incurred by performing the work proposed in the proposal’s objectives and tasks. Often the largest of these costs is direct labor, such as time for engineers and technicians to perform the proposed R&D goals. Other common direct costs include supplies, materials, equipment, consultants, subrecipients, and travel. For example, let’s say a company proposed to perform a field study on the effects of different fertilizers on plant growth and insect health. Purchasing the fertilizers and sample collection supplies, traveling to and from the site, the subcontractor hired to evaluate the insects, the researcher’s time spent working on the study would all count as direct costs.
Indirect costs aren’t tied to a specific award but are rather costs incurred which keep the business operating. Expenses including office rent, software subscriptions, legal and accounting fees, insurance, and administrative labor are all common indirect costs. Administrative labor can include personnel such as the finance, marketing, and sales teams. They also include employer payroll taxes and the benefits of all employees including paid time off, health insurance, and employer retirement contributions (this set of costs is often referred to as “Fringe & Benefits”). Indirect costs are grouped together and divided by the direct costs of performing work for customers, which results in an indirect rate percentage.
In the simplest terms it looks like this: [Indirect costs / direct costs = indirect rate %]
However, if it were actually that simple we wouldn’t be writing an article about it. The costs allowed to be counted in those two buckets, the number of tiers you use, how you apply them in your award, and the model each agency likes to use makes this a bit more complicated.
The government would prefer to only pay for direct costs, but they know that if they only reimbursed those, very few companies would work with them because it wouldn’t cover the other costs required to run their businesses. In the commercial world, this is covered by a markup on the goods and services you provide your customers with, which leads to your gross profit margin. The higher the markup, the better the gross profit margin, and the more indirect costs you can cover. This markup is limited by what the marketplace will pay for your goods and services. However, the government requires more transparency into your markup and this is where indirect rates come into play.
How do I get indirect rates?
Many funding solicitations allow you to propose indirect rates as part of your application. Different agencies use different models, for example:
Department of Defense (DoD) = Incurred Cost Electronically (ICE) model through the Defense Contract Audit Agency (DCAA)
National Science Foundation (NSF) = Negotiated Indirect Cost Rate Agreement (NICRA) through the Cost Analysis and Pre-Award Branch
National Institutes of Health (NIH) = Indirect Cost Submission through the Division of Financial Advisory Services (DFAS)
Generally, you negotiate rates with your “cognizant” agency, i.e. the place you receive a “preponderance of funding” from. The DoD model allows you to propose rates using a one-tier (General and Administrative (G&A), two-tier (G&A and Fringe), or even three-tier (G&A, Fringe, and Overhead) model. These each get applied to different pools of direct costs. For smaller grants, NSF typically prefers a one-tier model called a “Facilities and Administrative” (F&A) rate that is only applied to salaries and wages. Some agreements also allow a 7% “Fee” on top of all other costs.
It’s important to note that on certain award types, agencies will allow applicants to use a rate which does not require negotiation or documentation. For example, NSF and NIH both provide a “safe rate” on Phase I SBIRs: this is 50% for NSF but applied to just the labor pool, where as the NIH is 40% and applied to Modified Total Direct Costs (MTDC). More on MTDC later. NIH also considers Internal R&D costs to be “direct” since most healthcare companies spend years in development before they ever charge a customer.
Many agencies allow a 15% de minimis rate in lieu of a negotiation (this was raised from 10% on October 1st, 2024). This allows the agency to avoid negotiating rates with every individual awardee, which would be a massive administrative burden. However, it’s also a great option for lean teams in that you get to avoid calculating rates before your business has scaled, and occasionally the rate is higher than what you could negotiate anyway.
How are these rates applied to my award?
One other common point of confusion for organizations new to working with the government is how to apply the indirect rate percentage to the direct costs of the award. The majority of the time you are going to calculate and apply your rates using the Modified Total Direct Costs (MTDC) method, which mostly removes equipment and subwards (which are different from consultants. Consultants versus subcontractors versus subrecipients is an article for another time).
When we say “mostly remove” all but 50k for equipment, and 50k for each individual subaward is taken out of the direct cost base.
When you think about it, the logic behind this makes sense: Generally your indirect costs don’t scale just because you spent $100k on a big piece of equipment, or paid another organization $100k to perform work on the project. Whereas, if you paid a person $100k to perform work, there are a lot of indirect costs that go along with that (payroll taxes, benefits, office space, software, etc).
However, sometimes an agency (the DoE being the most common in our experience) prefers to use the Total Direct Cost (TDC) or Total Cost Input (TCI) method where all direct costs are included in the base. This means you will have a much lower rate, but it will be multiplied across a much larger direct cost base.
If you choose to employ the de minimis rate, it always uses the MTDC method.
Why are indirect rates so important?
There are a few ways to look at this, but essentially indirect rates become your profit margin on every direct dollar that you bill. This also means that they materially impact how much direct work you must perform to receive the full award amount. If you are the government, you prefer lower indirect rates because you get more work for every dollar. If you are the business performing the work, you would rather do less work for the same amount of money.
Take a simple NSF grant as an example: if you billed $100,000 of labor and $100,000 in supplies, you could bill $161,000 for labor by applying the 50% F&A “safe” rate and the 7% fee, while you could bill $107,000 for the supplies from the 7% fee. This would be a total bill of $268,000 for $200,000 in direct costs, which is a 25% “gross margin”. If you hadn’t used either rate, you would have had to spend $268,000 in direct costs to receive the same amount of money. This is often even more dramatic on DoD contracts. If you had the same direct costs and had a three-tier rate structure with 20% fringe, 20% overhead, and 30% G&A as well as a 7% fee, you could bill $200,000 for labor and $139,000 for supplies, which is a $339,000 total; the for a “gross margin” of 41%.
In the NSF case you received $68,000 in indirect dollars, while in the DoD case you received $139,000. It is up to you as the business owner what you do with these payments: you can pay rent, hire an additional employee, whatever your business needs to maintain operations. Many organizations fear that they need to allocate indirect dollars to specific projects in their accounting system. This is unnecessary. This is the cause of many headaches and we fight against this constantly on the accounting side. In the end, most projects are capped, and having higher rates will not generate any more top-line revenue on the project. However, having a reasonable rate allows you the flexibility to spend money on direct or indirect items. You don’t want to be in a spot where you have money left in your budget for direct line items and have to give it back (or spend on something you don’t really need) when you could have proposed decent rates and used those indirect dollars to cover operating exepenses like lawyers, facilities, or other G&A items.
What % are indirect rates typically?
It’s difficult to compare rates directly between businesses because they may use a different number of tiers or were calculated using different systems. It’s better to compare rates based on their “total multiplier”; for example, on a DoD three-tier rate with a 7% fee, applying all four rates on labor results in a single multiplier. The following reactions can be expected on different ranges of “total multiplier” on a DoD budget:
This is too complicated; can someone just do this for me?
Absolutely! At IBEX Consulting, we are experts at acquiring and managing federal funding. We provide services to support all aspects of government awards, from opportunity discovery to proposal development to award negotiations to project execution. We also provide accounting and strategic finance services to small businesses.
If you’d like us to help you navigate indirect rates or are interested in any of our other services, contact us and we will set up a time to discuss further!