By: Saul Jimenez
Key Takeaways:
- Engineering firms on public projects must properly categorize direct and indirect expenses for accurate FAR rate calculation.
- FAR rate sums up payroll, fringe benefit costs as direct labor percentage, and general overhead costs.
- Compliance with Federal Acquisition Regulation (FAR) requires adherence to AASHTO Guide.
- Independent audits, essential for many highway projects with state and federal funding, boost profitability and avoid penalties.
- The audit assesses internal control over financial reporting, compliance, and other matters per Government Auditing Standards.
- Audited rates are crucial for proposals and ‘cost plus’ contracts billing – higher rates yield higher contract earnings.
For engineering firms, ensuring that direct and indirect expenses are properly categorized is one of the most challenging aspects of cost reporting when working on public projects. This process is essential to calculating the correct overhead rate – or “FAR” rate – for a government project, whether a firm is the general contractor or a subcontractor.
The overhead rate is a calculation of the payroll and fringe benefit costs as a percentage of direct labor, as well as general overhead costs. They are summed up to determine the total overhead rate, which is used as a multiplier when a firm is performing a project for the state or federal government, including departments of transportation. The overhead rate represents a percentage of general expenses that companies such as engineering firms may bill to government agencies.
Importantly, these overhead rates must be compliant with the Federal Acquisition Regulation (FAR), and FAR Section 31 provides guidance on the allowable and unallowable costs that can be included in cost reports. Further guidance is available from the AASHTO Guide from the American Association of State Highway and Transportation Officials.
Audit Requirements
Because many highway projects involve both state and federal funding, the federal requirement for an audit by an independent audit firm to determine compliance with the FAR Section 31 cost principles comes into play for engineering firms. Many companies don’t want to invest the time and expense for this audit, but it is required and failure to obtain the audit may result in the state agency auditing your cost reports.
It’s important to note that an independent audit of your overhead rate and cost reports can yield valuable information that can help you improve the profitability of the public projects your firm works on. Your overhead rate could be higher than what the state agency deems appropriate, which could result in your firm being charged penalties and interest. Another troublesome area is the mislabeling of expenses. For example, entertainment expenses typically are not allowable; but if they are for employee team building, they could be allowed. An experienced auditor will know the difference and advise you.
If an auditor sees that your overhead rate is higher than normal or is rising, it could indicate your company is carrying more costs than it should. Conversely, a lower overhead rate indicates a lean organization. But even a low overhead rate can indicate weakness if the company is struggling.
Typically, an overhead rate audit is done immediately following a company’s financial statement audit.
The Audit Process
The typical audit process involves an engineering firm’s accounting and management teams preparing the Schedule of Indirect Costs in accordance with accounting practices prescribed by FAR Section 31.
The auditor audits the Schedule of Indirect Costs and the related notes to ensure there are no material misstatements. The auditor conducts the audit in accordance with auditing standards generally accepted in the United States of America and the standards applicable to financial audits contained in Government Auditing Standards, issued by the Comptroller General of the United States.
The auditor also issues a report on internal control over financial reporting and on compliance and other matters based on an audit performed in accordance with Government Auditing Standards.
Audited overhead rates ultimately are used for a number of purposes, including submission of proposals to various government agencies, as well as billings on “cost plus” contracts. These contracts allow companies to bill for costs plus the approved overhead rate. The higher the rate, the more the company can get paid for their contracts.
How We Can Help
If your engineering firm needs help determining its overhead rate or if you require an audit, contact your KRD advisor.
