The assumption that costs contractors money
If you hold fixed-price (FP) or time-and-materials (T&M) contracts instead of cost-reimbursable ones, it's easy to assume indirect rates are someone else's problem — a DCAA compliance exercise for contractors who bill the government dollar-for-dollar. That assumption is wrong, and it's an expensive one.
Indirect rates aren't primarily a compliance tool. They're a profitability tool, and FP and T&M contractors need them just as much as cost-type contractors do, even if no one ever audits the number.
Why gross margin lies to you
Gross margin — revenue minus direct costs — tells you whether a contract covers the direct cost of delivering it. It says nothing about whether that contract is covering its share of rent, insurance, admin salaries, business development, IT, and every other cost that exists to keep the company running.
A contract can show a healthy 40% gross margin and still be losing the company money once indirect costs are allocated to it. Gross margin answers “did this job cost more to deliver than we billed for it?” It doesn't answer “is this job actually profitable once the business absorbs its share of overhead?” Only an indirect rate calculation answers the second question.
Worked example
Meridian Systems Group, a hypothetical 12-person IT services firm, holds a mix of T&M and firm-fixed-price contracts. No cost-reimbursable work, so no one has ever asked them to compute an indirect rate.
Basic financials, one year
| Total revenue | $2,100,000 |
| Direct labor (billed staff wages) | $650,000 |
| Other direct costs (subcontractors, travel, direct materials) | $150,000 |
| Total direct costs | $800,000 |
| Gross margin | $1,300,000 (62%) |
On the surface, that looks like a strong business. But look at what's below the direct cost line:
Indirect costs, same year
| Fringe (payroll taxes, health insurance, PTO on billed staff) | $180,000 |
| Overhead (non-billed technical staff, project management support, facility costs tied to delivery) | $340,000 |
| G&A (executive comp, admin/HR/finance staff, business development, general office costs) | $520,000 |
| Total indirect costs | $1,040,000 |
Building the rates
A simplified version, using direct labor as the base for fringe and overhead, and total cost input as the base for G&A:
| Pool | Amount | Base | Rate |
|---|---|---|---|
| Fringe | $180,000 | Direct labor ($650,000) | 27.7% |
| Overhead | $340,000 | Direct labor ($650,000) | 52.3% |
| G&A | $520,000 | Total cost input ($1,320,000) | 39.4% |
What this means per billed labor dollar
Take one employee billed at $100/hour on a T&M contract, with a $50/hour direct wage rate.
- Direct labor$50.00
- Fringe (27.7%)$13.85
- Overhead (52.3%)$26.15
- Subtotal before G&A$90.00
- G&A (39.4% applied to that subtotal)$35.46
- Fully burdened cost to deliver that hour$125.46
The firm is billing $100/hour for labor that actually costs $125.46 fully loaded. Every hour that employee bills, the company loses money — invisible in a gross margin calculation, glaring in a fully burdened rate calculation.
The company-wide picture: apply the same logic across the whole revenue base and Meridian isn't sitting on a 62% gross margin business. Once indirect costs are allocated proportionally, several of its T&M contracts are running at breakeven or a loss, while a couple of fixed-price contracts — priced with wider margins — are carrying the rest of the company. Without calculating indirect rates, Meridian's leadership would have no way to know which contracts to renegotiate, re-bid higher, or walk away from.
How to calculate it without building a DCAA-grade system
You don't need incurred cost submissions or DCAA-level infrastructure to get value from this. A simplified annual calculation is enough for most FP/T&M contractors:
- Classify every cost as direct (tied to a specific contract) or indirect (fringe, overhead, or G&A).
- Pool the indirect costs into fringe, overhead, and G&A — or even just one combined indirect pool if the business is small enough that three pools add more complexity than insight.
- Choose an allocation base — direct labor dollars is the most common and simplest for a labor-driven services firm.
- Divide each pool by its base to get a rate, and apply the rates cumulatively (fringe and overhead onto direct labor, G&A onto the subtotal) to get a fully burdened cost.
- Compare fully burdened cost to your billing or contract price, contract by contract. That's your real margin.
This can be done once a year in a spreadsheet. It doesn't require a cost accounting system, a DCAA-compliant chart of accounts, or outside help — though getting it built correctly the first time is where most contractors benefit from outside expertise.
When to formalize it
An annual back-of-envelope version is enough for a contractor with a handful of contracts and no near-term plans to pursue cost-type work. It's time to build a real indirect rate structure — documented pools, a consistent allocation methodology, and rates recalculated at least annually and compared to budget — once any of these is true:
- The company is bidding on cost-reimbursable work
- A prime contractor or agency has asked for provisional billing rates
- The business has grown past the point where one person can eyeball profitability by contract
- Leadership is making pricing decisions without knowing the real fully burdened cost of labor
At that point, it's not just a profitability exercise anymore — it's the same rate structure discussed in the guide on avoiding a DCAA audit, so getting it right now means it's already in place if the company grows into cost-type work later.
Frequently asked
Do T&M contractors need indirect rates?
Not for compliance, in most cases — but yes, for pricing and profitability. Without rates you can't know your fully burdened cost per hour, which means you can't tell whether a billing rate leaves any margin once overhead and G&A are covered. And if you later bid cost-reimbursable work or a prime asks for provisional billing rates, you'll need the structure anyway.
Is gross margin enough to measure GovCon profitability?
No. Gross margin only shows whether revenue exceeded the direct cost of delivery. It ignores rent, insurance, admin salaries, business development, and everything else that keeps the company running — so a contract with a strong gross margin can still lose money once its share of indirect cost is allocated to it. Only a fully burdened rate calculation tells you which contracts are actually profitable.
Want your rates calculated properly?
I build indirect rate structures for small and mid-sized government contractors — fringe, overhead, and G&A pools, a documented allocation methodology, and a fully burdened cost per hour you can price against.