The Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) program funding increases compliance requirements when transitioning from Phase I to Phase II Cost-Plus-Fixed-Fee (CPFF) contracts. The increase in compliance requirements is most evident with Department of Defense (DoD) awards. The heightened accounting requirements are crucial for accurate cost estimation, compliance, audit readiness, and financial stability. Indirect costs, such as rent, utilities, and administrative salaries, are a critical component of cost-plus contracts. To ensure reimbursements align with actual expenses and comply with federal regulations, including the Federal Acquisition Regulation (FAR) and Defense Contract Audit Agency (DCAA) standards, meticulous estimation of proposed indirect rates is required. This article outlines best practices for accurately estimating indirect costs under a cost-plus SBIR contract, ensuring compliance and maximizing profitability.
Understanding Indirect Costs in Cost-Plus SBIR Contracts
In a cost-plus contract, the government reimburses allowable costs (both direct and indirect) plus a fixed fee, typically 7–10% of the costs. This shift to cost reimbursement places financial risk on the government. Therefore, the government requires the contractor to maintain robust cost tracking and documentation. [8] Indirect costs, also known as fringe, overhead, Facilities and Administration (F&A) or General and Administration (G&A) costs, are expenses not directly attributable to a specific project but necessary for the organization’s operations. Indirect costs include rent, utilities, administrative salaries, and insurance[2][7].
For SBIR Phase II recipients, accurately estimating and allocating these costs is crucial. As they are subject to scrutiny during DCAA pre-award surveys (SF 1408), Incurred Cost Audits, or agency-specific reviews, such as the National Science Foundation’s (NSF) Cost Analysis and Pre-Award (CAP) process [2][8]. Mismanaging indirect costs can result in disallowed costs, repayment demands, or suspension of funding. [5]
Best Practices for Estimating Indirect Costs
To ensure accurate, compliant, and auditable indirect cost estimates under a cost-plus SBIR contract, recipients should follow these best practices:
1. Identify and Track All Indirect Costs
Practice:
Separate indirect costs (e.g., rent, utilities, administrative salaries, office supplies, general liability insurance) from direct costs (e.g., project-specific labor, materials, subcontractors) in your accounting system. Group similar indirect expenses into cost pools, such as project management, quality control, or equipment-related costs, for easier analysis and allocation[5][6][7]. For example, a construction contractor might create separate pools for project management salaries and equipment maintenance costs to reflect their distinct roles in supporting projects[6].
Why It Matters:
Proper segregation prevents the commingling of funds, a common audit failure noted by the DCAA. [2] It ensures the appropriate segregation of indirect costs from direct costs. It also mitigates the risk of double charging and audit disallowances. [7]
Implementation:
Use accounting software to categorize costs into direct and indirect accounts. Set up a chart of accounts that distinguishes indirect cost pools (e.g., “Overhead – Administrative Salaries”) from direct costs (e.g., “Direct Labor – SBIR Project A”). Regularly review your profit and loss (P&L) report to verify cost classifications[6].
2. Select Appropriate Allocation Bases
Practice:
Choose allocation bases that logically distribute indirect costs to projects or funding sources based on their consumption of resources. Common bases include direct labor hours, direct labor costs, or project revenue. For instance, allocate office rent based on the square footage or administrative salaries based on direct labor hours. [2][5][7] The base must be reasonable, equitable, and reflective of how you consume resources, as required by the Uniform Guidance (2 CFR 200)[7].
Why It Matters:
An inappropriate allocation base can result in an inequitable distribution of costs, leading to audit findings or underfunding of indirect costs. For example, using direct labor hours for a project with no labor costs would unfairly exclude it from sharing indirect costs[7].
Implementation:
Analyze your operations to select bases that align with cost usage. For a small business with significant labor costs, tracking direct labor hours or costs can be a practical approach to managing expenses. Document the rationale for each base in a cost allocation plan, as recommended by the Office of Inspector General (OIG) reviews[7].
3. Calculate Indirect Rates Using Accurate, Current Data
Practice:
Calculate indirect rates by dividing the total indirect cost pool by the chosen allocation base (e.g., Modified Total Direct Costs (MTDC), Total Cost Input (TCI), etc.). Use the most current audited financial data or historical records to ensure accuracy, and update rates at least quarterly to reflect changes in business conditions, such as increased rent or insurance premiums[2][3][7]. For example, if indirect costs are $150,000 and direct salaries are $1,000,000, the indirect rate is 15% ($ 150,000 ÷ $1,000,000)[7].
Why It Matters:
Outdated or inaccurate data can lead to under- or over-allocation, causing cash flow issues or audit disallowances. All agencies scrutinize indirect rate calculations, particularly for CPFF contracts. Companies must justify their rates with historical or budgeted data. [2][8]
Implementation: Use recent profit and loss (P&L) reports or audited financial statements to calculate rates. For organizations without a negotiated indirect cost rate agreement (NICRA), consider the 10% de minimis rate on MTDC allowed by the Uniform Guidance, but verify it covers your indirect costs by comparing it to your actual rate[7].
4. Maintain Detailed Documentation
Practice:
Document your methodology for calculating and allocating indirect costs in a written plan, as required by the Uniform Guidance. Include details on cost pools, allocation bases, and rate calculations, and retain supporting records (e.g., invoices, timesheets, contracts) for at least six years to support audits[7][8]. For example, maintaining timesheets that show labor allocation across projects and funding sources is crucial, as OIG audits frequently cite undocumented salary costs as a common issue. [7]
Why It Matters:
Comprehensive documentation ensures auditability and compliance with FAR and DCAA standards. A lack of documentation, such as missing timesheets or travel receipts, can result in disallowed costs [2][7].
Implementation:
Create a digital or physical compliance binder with all relevant records. Use accounting software to generate audit trails, and ensure timesheets are signed, approved weekly, and coded to specific projects or indirect cost pools [2][5].
5. Automate Tracking and Reporting
Practice:
Use accounting software (e.g., QuickBooks, etc.) or enterprise resource planning (ERP) systems to automate the tracking, allocation, and reporting of indirect costs. Integrate accounting, timekeeping, and payroll systems to streamline data collection and ensure consistency across all systems. For example, automate labor cost allocation using timesheet software, such as Clockify [1][3][5].
Why It Matters:
Manual processes increase the risk of errors, which can lead to audit failures or financial losses. Automation improves accuracy, reduces administrative burden, and ensures real-time data for cost-plus contract reporting, such as Incurred Cost Proposals (ICPs)[3][5].
Implementation:
Invest in software that supports DCAA-compliant features, such as cost segregation and labor distribution. Set up contra accounts in your chart of accounts to track costs, allocations, and other crucial compliance elements [6].
6. Review for Reasonableness and Compliance
Practice:
Regularly assess indirect cost allocations for reasonableness and compliance with FAR Part 31 and agency-specific guidelines. Ensure that costs in the indirect pool are not charged directly to projects, as this constitutes double charging, a violation noted in the Uniform Guidance[7][8].
Why It Matters:
Non-compliance can result in disallowed costs, repayment demands, or loss of future awards. The DCAA’s SF1408 checklist and NSF’s CAP reviews emphasize the exclusion of unallowable costs (e.g., alcohol, fundraising) and the consistent application of allocation bases [2][7][8].
Implementation:
Conduct internal audits on a monthly or quarterly basis to verify cost classifications and allocations. Engage a CPA familiar with SBIR accounting to review compliance with FAR and agency requirements before submitting proposals or ICPs[5][7].
7. Adjust for Changes in Business Conditions
Practice:
Monitor changes in labor projections, insurance rates, rent, or other overhead expenses that could impact your indirect rate. Adjust calculations and allocations quarterly or as needed to reflect these changes, ensuring rates remain accurate and sustainable. For example, a spike in utility costs due to increased facility usage should prompt a rate adjustment[2][5].
Why It Matters:
Unadjusted rates can lead to over- or under-billing, which can affect cash flow or trigger audit issues. The construction industry, for instance, adjusts rates quarterly to account for seasonal variations or bulk purchases[6].
Implementation:
Use budgeting tools to forecast indirect costs and compare them to historical rates. Update your cost allocation plan to reflect any changes, and document the adjustments for audit purposes. [2][6]
Integration with Cost-Plus Pricing Strategies
Indirect cost estimation aligns closely with cost-plus pricing strategies used in SBIR contracts. The cost-plus model, where budgets include costs plus a fixed fee, relies on accurate cost data to ensure accuracy and compliance [1][3][4]. In SBIR Phase II, a fixed fee (typically 7–10%) is applied to allowable costs, including indirect costs, making accurate estimation critical to avoid underfunding or overbilling [8]. For example, underestimating indirect costs could result in unrecovered expenses, while overbilling could lead to repayments or allegations of fraud [3][7].
Conclusion
Accurately estimating indirect costs in a cost-plus SBIR contract is essential for compliance, audit readiness, and financial stability. By identifying and tracking indirect costs, selecting appropriate allocation bases, using current data, maintaining detailed documentation, automating processes, ensuring compliance, and adjusting for business changes, SBIR recipients can meet federal requirements and protect their funding. These best practices, grounded in FAR, DCAA, and Uniform Guidance standards, mitigate risks like disallowed costs and audit failures, as demonstrated by BioMedomics’ success. Leveraging tools like NetSuite, Deltek Costpoint, or Hour Timesheet, and consulting SBIR-experienced accountants, ensures a robust accounting system that supports innovation and commercialization in the competitive SBIR landscape.
References
- NetSuite: Cost-Plus Pricing: https://www.netsuite.com/portal/resource/articles/financial-management/cost-plus-pricing.shtml
- Wipfli: Reviewing Your Indirect Cost Allocation Methods: https://www.wipfli.com/insights/articles/cre-tax-reviewing-your-indirect-cost-allocation-methods
- HubiFi: Expected Cost Plus Margin: https://www.hubifi.com/blog/expected-cost-plus-margin/
- Altosight: Cost-Plus Pricing Strategy: https://altosight.com/what-is-cost-plus-pricing-strategy-formula-examples/
- Seven Figure Agency: Implementing Cost-Plus Pricing: https://sevenfigureagency.com/implementing-cost-plus-pricing-agency-revenue-model-insights/
- CLA: Managing Indirect Costs for Construction: https://www.claconnect.com/en/resources/articles/2018/managing-indirect-costs-best-practices-for-your-construction-business
- RCAC: Understanding Cost Allocation and Indirect Cost Rates: https://www.rcac.org/understanding-cost-allocation-and-indirect-cost-rates/
- Legitt AI: Cost-Plus Contracts: https://legittai.com/blog/cost-plus-contracts
