Gail & Jim Greenwood, Greenwood Consulting Group, Inc.

Copyright © 1999 by Greenwood Consulting Group, Inc.

One of the most misunderstood aspects of the SBIR proposal is the last couple of pages in which the company presents its cost proposal. A lot of thought and planning should go in to the cost proposal, but it often appears to be something that is handled by the applicant at the last minute and with relatively little thought.

While a complete discussion of government accounting is beyond what we can cover here, we do want to make some comments about the key concept of direct and indirect costs. Direct costs are those that are incurred because you are working on a specific project, such as a Phase I or Phase II SBIR effort. They usually include the labor involved in performing the project tasks, and may also include materials, equipment purchase or leasing, travel, and subcontracts to other organizations and consultants related to those tasks.

In contrast to direct costs are indirect costs. These are defined as the costs that are incurred either (1) while performing work that is applicable to multiple projects or (2) as part of just "being in business." An example of the former subcategory is a meeting between your company’s staff and subcontractors regarding two separate projects that you are teaming on—since multiple projects will be discussed, the labor and other costs associated with such a meeting would be considered as an indirect costs. The latter subcategory includes a wide range of costs that you would expect to incur when you are in business: rent, utilities, phone, clerical support, proposal preparation time, employer-paid payroll taxes, fringe benefits, conference attendance are some common examples. Indirect costs can be further divided into a number of sub-subcategories, such as overhead, fringe, and G&A.

When preparing the SBIR cost proposal, you have an opportunity to ask the federal agency to pay the direct costs of performing the project AND a portion of the indirect costs that your company has to cover. That portion should be based on some reasonable allocation method, such as how much this SBIR project would represent as a fraction of your firm’s revenues from all projects it anticipates having during some time period, such as the calendar or fiscal year during which you would work on the SBIR effort. For example, if you anticipate generating $1.5 million in revenues in calendar year 2000 and this is a $100,000 Phase I request, it represents 6.7% of your anticipated revenues and you would allocate 6.7% of your anticipated indirect expenses to this Phase I project.

Having said this, here are a number of places where SBIR applicants have problems when it comes to indirect costs on their proposal:

The applicant has never calculated an indirect rate for their firm. It’s pretty darn hard to ask the agency to reimburse you for something that you haven’t calculated. No big deal, you think? We think this is a big deal, because indirect costs are the things that you need to pay to stay in business, and how can you hope to do so if you don’t know what they are or bill customers for them?

Use someone else’s indirect rate. We’ve been asked "the place where I used to work charges an indirect rate of 55%, so isn’t that good enough for me to use?" There is likely little correlation between the indirect costs of a university or another firm and yourself, so this strategy does not make much sense.

Use the same indirect rate you used last year. Small businesses often see radical changes in the indirect rates over time, so using an old rate often doesn’t work well.

Don’t ask for reimbursement for indirect costs. All too often, we will see Phase I SBIR and STTR proposals in which the applicant is not requesting that the agency reimburse them for any indirect costs. Some agencies even give you an incentive (probably unintentionally) to not ask for them to pay any of your indirect costs. For example, those of you who are preparing an NIH Phase I application for the December 15^th deadline will see an opportunity on Part 3 of the Checklist to indicate that no indirect cost reimbursement is being requested.

Again, this is a bad idea, in our opinion. If you don’t charge the agency for any indirect costs on this project, then how will you cover these costs? If you bill other customers for more than their share of these costs to cover your failure to bill any indirect costs to the SBIR agency, is that fair? And what would an auditor representing one of those other clients think of such an approach?

We sometimes hear from start-up firms that they don’t have any indirect costs since they will only have this one SBIR project and therefore all of their costs would be direct ones. This likely is not true. Even a one-project company is probably going to be preparing other proposals, keeping time sheets (as required by the SBIR agencies), filing tax reports, doing some schmoozing to improve their chances of a Phase II award, etc—all of these costs suggest that this firm has indirect costs and needs to calculate an indirect rate to bill for them.

Use different indirect rates for different proposals. This is a problem closely related to #4 above. Companies mistakenly think an indirect rate is "project specific," and therefore a different rate is calculated for each. In reality, a single indirect rate should be determined and then applied to all projects during the time period that was used when the rate was estimated.

A final caution: some agencies have established a maximum indirect rate that they will accept. Sometimes that maximum is absolute, while other times it is the highest rate they will accept unless you justify a higher rate. In the latter case, the maximum is almost always lower than what you deserve and can justify. For example NIH has a cap of a 40% indirect rate (as a % of all direct costs) on Phase Is, unless you have a previously approved rate, and 25% of Phase IIs unless you negotiate a higher one. Do not accept these artificially low rates without a fight! If you have had another government project for which you had an indirect rate higher than 40%, use it on your Phase I NIH proposal. And you should be able to justify and negotiate a much higher rate than 25% on your Phase II NIH.

We are the first to admit that all of this is painful and confusing, but it is an important part of competing for SBIR, STTR and other government funding. Indirect costs also are an important consideration in pricing your goods and services to any customer, whether the government or otherwise. If you are not comfortable with calculating an indirect rate for your firm or with the reams of regulations that accompany government procurement, we recommend that you seek the counsel of an accountant with government accounting knowledge and experience, ask another firm with good SBIR/STTR experience for some advice, and/or attend appropriate training.