Overhead Rate

An overhead rate is an indirect cost pool rate applied to direct labor costs (or another allocation base) to recover costs that benefit multiple contracts but cannot be specifically identified with any single one, such as facilities costs, equipment depreciation, direct supervision labor, and project-level support costs, expressed as a percentage of the allocation base.

What is an Overhead Rate?

Overhead is the middle layer of the indirect cost stack, sitting above fringe benefits and below G&A in a typical cost accounting structure. While fringe recovers employee benefits costs and G&A recovers corporate-level costs, overhead recovers the costs of operating the delivery function: the offices and labs where work is performed, the equipment used to perform it, the direct management and supervision of contract staff, and other costs that support the direct labor force without being directly billable to a contract.

Common overhead cost components include: office space and utilities attributable to direct operations, depreciation on lab equipment and computers used on contract work, administrative support directly associated with project execution, project-level training costs, and direct program management overhead. The overhead allocation base is typically direct labor dollars, though direct labor hours or total direct costs are also used.

Government contractors may maintain separate overhead pools for different operating groups, a company with both a government services division and a commercial division may maintain separate overhead pools for each, preventing commercial overhead costs from inflating the rates charged to government contracts. Some contractors further segment overhead pools by facility location, especially on large cost-plus contracts where work is performed at different sites with materially different facility costs.

DCAA verifies that overhead costs are allowable (permitted under FAR Part 31), allocable (genuinely benefit the contracts to which they are allocated), and reasonable (not excessive relative to the services performed). Direct charging of items that should be overhead, such as billing an individual computer as a direct cost when it is used across multiple contracts, is a common finding.

Why the Overhead Rate Matters for Government Contractors

Overhead rate management directly affects competitiveness on cost-type and T&M contracts. Contractors with high facility costs relative to their revenue base carry higher overhead rates and are structurally disadvantaged in labor-rate comparisons. Revenue growth (spreading fixed overhead costs over a larger direct labor base) is the primary mechanism for reducing overhead rates. Facility right-sizing, work-from-home policies that reduce dedicated office footprint, and equipment sharing agreements all contribute to overhead rate reduction.

Example

A 60-person defense engineering firm operates from 12,000 sq ft of leased office space in Herndon, VA at $42/sq ft annually. Annual overhead pool costs: rent and utilities ($504,000), office equipment depreciation ($87,000), lab/test equipment depreciation ($132,000), IT infrastructure allocated to direct operations ($95,000), and direct supervisory labor not charged to contracts ($215,000). Total overhead pool: $1,033,000. Direct labor base: $5.8M. Overhead rate: $1,033,000 / $5,800,000 = 17.8%. The rate is applied to all direct labor charges on the firm's cost-type contracts.

Frequently Asked Questions

Can a contractor have more than one overhead rate?

Yes. Contractors with multiple operating divisions or facility locations commonly maintain separate overhead pools, each with its own rate, applied to the direct labor of the employees in that division or location. A large defense contractor may have separate rates for each site (where facility costs vary dramatically) and separate rates for manufacturing versus engineering functions (where cost structures differ). FAR 31.203(b) allows multiple overhead pools as long as the allocation is equitable and the cost accounting structure is consistent.

What is the difference between overhead and G&A?

Overhead costs benefit a subset of a contractor's work, typically the direct program delivery function for a particular division or facility. G&A costs benefit the entire enterprise, including all business units, all programs, and all indirect functions. The classification matters because G&A is applied after overhead, on a broader base (total cost input or value-added base), and typically at a lower rate than overhead. Misclassifying G&A costs as overhead (or vice versa) results in incorrect cost allocation across contracts and is a DCAA audit finding.

How are overhead rates established for proposal purposes?

Contractors use their most recent audited rates or DCAA-approved forward pricing rate agreements (FPRAs) as the basis for proposed overhead rates. For companies without FPRAs, the contracting officer reviews proposed rates during negotiation and may request a DCAA rate review prior to award. Proposed rates should be supported by the contractor's accounting records and reflect realistic expectations for the contract period. Proposing artificially low overhead rates to win competitive procurements, when actual costs will be higher, constitutes a misrepresentation.

What happens if actual overhead costs are higher than the proposed rate?

On cost-type contracts with provisional billing rates, the contractor bills the government at the provisional rate during performance and submits an incurred cost submission after the fiscal year closes. If audited actual rates are higher than provisional rates, the government pays the additional cost up to the contract's ceiling and the cost accounting rules for allowability. On T&M contracts, the billing rates are fixed, the contractor absorbs the variance between actual overhead costs and the overhead component baked into the fixed billing rates.