Provisional Billing Rates and Rate Variance

On a cost-reimbursable contract, a contractor cannot wait until year end to find out what its indirect rates were before billing. Work is performed in January and has to be invoiced in February. So the government allows billing at estimated rates during the year, with a true-up once actual rates are known and audited. That mechanism is the provisional billing rate, and the space between the estimate and the actual is where a surprising amount of GovCon financial pain lives.

How Provisional Rates Get Set

FAR 42.704 gives the cognizant contracting officer or auditor authority to establish billing rates for interim payment purposes. In practice the contractor proposes rates based on its budget for the coming year, the cognizant agency — often DCAA on behalf of the ACO — reviews the basis, and rates are approved for billing.

The regulation is explicit that these rates are meant to approximate the final rates as closely as possible, and that they are to be adjusted during the year when it becomes apparent they will differ materially from what actually happens. That second half is the part contractors ignore.

The Two Directions of Variance

Billing above actual. If provisional rates are set high and actual rates come in lower, the contractor has been overbilling all year. At settlement, the difference is repaid. For a company with thin working capital this is not an accounting entry — it is a cash event, arriving typically eighteen months to several years after the money was collected and spent. Contractors who have grown through the intervening period discover the liability attaches to a much smaller company than the one now paying it.

Billing below actual. If provisional rates are set low and actuals come in higher, the contractor has financed the government's work out of its own balance sheet all year. The money is recoverable at settlement, subject to contract funding and ceilings — but recoverable eventually is not the same as available now, and the cost of carrying it is real.

Neither direction is safe. Conservative rate-setting is not a virtue here; accuracy is.

Why Rates Drift

Rates drift because a rate is a ratio, and both halves move independently.

• The base moves faster than the pool. A contractor wins a large program and direct labor jumps 40%. Indirect costs do not scale proportionally in the short run, so actual overhead and G&A rates fall well below provisional. The contractor has been overbilling since the award.
• The base collapses. A recompete is lost, or a program is descoped, or a continuing resolution delays award. Direct labor falls, indirect costs are largely fixed, and rates spike. The contractor is now underbilling and absorbing the shortfall.
• Contract mix shifts. Moving from labor-heavy work to a program with heavy subcontract content changes the total cost input base sharply, which moves G&A even if nothing about the cost structure changed.
• The pool moves. A facility lease is signed, an executive team is built out, a bid and proposal push is funded. Indirect costs rise against a flat base.

Each of these is a normal business event. What makes them a compliance and cash problem is discovering them in the incurred cost submission rather than in month three.

Managing Variance During the Year

The discipline is not complicated, which is why it is frustrating that it is so often absent.

The Diligence Angle

In a transaction, provisional rate variance surfaces fast, and it surfaces in a way that is difficult to argue with. A quality of earnings provider will compare billed indirect to actual indirect for every open year and compute the settlement exposure directly.

What follows depends on the size of the number and, more importantly, on whether the seller already knew about it. A quantified, disclosed, reserved-for exposure is a negotiation about escrow size. An exposure the buyer finds that management did not know about is a different conversation — it recalibrates the buyer's confidence in every other management representation, and the price of that is rarely limited to the item itself.

The contractors who handle this well are not the ones with no variance. Variance is normal. They are the ones who can produce a schedule showing, by year, the provisional rates billed, the actual rates incurred, the resulting exposure, and the reserve carried against it — before anyone asks.