What Are Indirect Rate Overhead Audits and When Are They Required?

BRYNN MCNEIL: Welcome to Cherry Bekaert's Professional Services Podcast. My name is Brynn McNeil, and I'm an audit partner focused on serving architectural and engineering firms.

BRYNN MCNEIL: Along with me today is Mandy Crowder, senior manager in our audit practice, who has worked for a number of years serving architectural and engineering firms.

BRYNN MCNEIL: Today we will focus on indirect overhead rate audits: what they are, what drives the requirement, key considerations for navigating them, and best practices for preparing.

BRYNN MCNEIL: Mandy, can you give an overview of an indirect overhead rate audit and what drives the requirement so a firm can determine whether it needs one?


MANDY CROWDER: An overhead rate is the ratio of the firm's allowable indirect costs to its direct labor costs, determined under the Federal Acquisition Regulation.

MANDY CROWDER: The overhead rate allows companies to recoup from the government costs that are necessary to run the business but do not directly relate to a specific contract or project.

MANDY CROWDER: We often use the terms indirect rate and overhead rate interchangeably.

MANDY CROWDER: An overhead rate audit is a process by which auditors determine that the costs included in the rate calculation are allowable under the FAR.

MANDY CROWDER: The audit typically involves expense testing, control walkthroughs, and analyses, and it results in a report that indicates the overhead rate for the company for the year along with an auditor's opinion.

MANDY CROWDER: When companies propose work for state departments of transportation, those DOTs typically request audited overhead rates.

MANDY CROWDER: A common question from A&E firms is whether all firms doing work with state DOTs need an overhead rate audit.


BRYNN MCNEIL: If you are a newer or smaller firm just starting to work with a state DOT, you may not have sufficient contract cost history to develop an indirect cost rate.

BRYNN MCNEIL: For those firms, we often recommend using a safe harbor rate rather than undergoing a complex audit until you have established contract cost history and are doing more work in the field.

BRYNN MCNEIL: If a smaller percentage of your work is DOT-related, the cost of the audit may outweigh the benefits.

BRYNN MCNEIL: Once you have sufficient contract cost history and are pursuing more work, state DOTs will expect an audited rate.


MANDY CROWDER: Once a company has reached the size and level of activity where an audit is recommended, there are critical components to address in the audit process.

MANDY CROWDER: Two primary areas are timekeeping and labor charging controls and systems, and the allowability of overhead expenses.

MANDY CROWDER: Direct labor is a major driver of the overhead rate calculation, so accurate labor charging is essential.

MANDY CROWDER: Indirect costs included in the rate must also be allowable under the FAR.


BRYNN MCNEIL: What are the key controls and practices firms should consider for timekeeping and labor charging?


MANDY CROWDER: Firms must maintain sufficient controls to monitor and accurately record labor costs.

MANDY CROWDER: First, the distinction between direct labor and indirect labor must be maintained.

MANDY CROWDER: Direct labor is time worked by employees for the specific benefit of a contract or project.

MANDY CROWDER: Indirect labor is time worked for general business purposes that do not directly benefit a specific contract.

MANDY CROWDER: Controls should allow employees to record time appropriately between direct and indirect labor.

MANDY CROWDER: Timesheets must be reviewed and approved by supervisors who can attest to accuracy and completeness.

MANDY CROWDER: Employee pay rates used to calculate compensation should be approved by an authorized individual in the company.

MANDY CROWDER: Overtime hours and associated costs require additional consideration due to nuance and complexity; companies should keep this on their radar when designing timekeeping and labor charging policies.


BRYNN MCNEIL: What should companies consider regarding cost allowability for overhead expenses?


MANDY CROWDER: Step one is reading FAR Part 31, which contains rules on allowable costs.

MANDY CROWDER: At a high level, allowable costs are reasonable, allocable, and not expressly unallowable under the FAR.

MANDY CROWDER: Expressly unallowable costs are disallowed 100 percent and include categories such as reimbursed employee meals, bad debt, contributions to charitable organizations, entertainment, for example, a holiday party, and lobbying.

MANDY CROWDER: There are also many cost categories that are gray areas with room for interpretation. These areas make audits challenging because auditors must apply and interpret the standards.

MANDY CROWDER: High-risk areas where we typically find unallowable costs include travel, employee attendance at seminars and conventions, and professional services or consultant fees.

MANDY CROWDER: For travel, the FAR has specific rules about allowable portions of hotel stays and meals; we often reference GSA per diem rates to determine allowable amounts.

MANDY CROWDER: When employees attend seminars and conventions, distinguishing between networking, generally unallowable, and educational seminars, potentially allowable, requires judgment.

MANDY CROWDER: For consultants and professional services, documentation requirements must be met to support allowability.

MANDY CROWDER: Executive compensation is another significant focus. The FAR includes rules on allowable compensation for bonus plans, incentive compensation, deferred compensation, and similar items.

MANDY CROWDER: There is also a reasonableness component: compensation should be comparable to peer firms of similar size, revenue, and work type.

MANDY CROWDER: Excessive compensation compared to peers may be considered unreasonable and subject to disallowance.

MANDY CROWDER: Tools to assess reasonableness include AASHTO's National Compensation Matrix and industry compensation surveys from architecture and engineering firms.


BRYNN MCNEIL: Do you have best practices for preparing for and successfully completing an overhead rate audit?


MANDY CROWDER: Firms should evaluate their accounting and timekeeping systems to ensure they support job-cost accounting so employees can charge time and expenses and segregate between direct and indirect costs on each job.

MANDY CROWDER: An accounting system capable of tracking job costs will facilitate audit readiness.

MANDY CROWDER: Maintaining an audit trail and supporting documentation is critical.

MANDY CROWDER: Keep timesheets with supervisor approvals to support the labor component.

MANDY CROWDER: Retain detailed invoices for overhead expenses to demonstrate appropriateness.

MANDY CROWDER: For travel, retain hotel invoices to determine locality and any disallowed amounts, and maintain schedules showing the portions of expenses that were disallowed.

MANDY CROWDER: Document your processes and procedures for recording costs, approving costs, and processing payroll in narrative form.

MANDY CROWDER: These policies and procedures are important during the audit and can be developed with outside assistance if needed.

MANDY CROWDER: With good systems and documentation, these audits can proceed smoothly. We have conducted many successful overhead rate audits over the years.


BRYNN MCNEIL: Thank you for joining me today.

BRYNN MCNEIL: This podcast is part of our Professional Services series, and we will be producing more episodes. This will also be posted on cbh.com.

BRYNN MCNEIL: If you have questions or needs, please feel free to reach out to Mandy or myself. Even if you are not a client of the firm, we can help answer questions.

BRYNN MCNEIL: Thank you for joining us.