For many SBIR and STTR companies, indirect rates become a much bigger concern when preparing for Phase II.

 

Phase I may have been smaller, shorter, or easier to manage with a basic financial structure. But Phase II often brings larger budgets, more labor, more vendors, more reporting, and more pressure to show that the company can manage federal funds responsibly.

 

One of the biggest questions is: what indirect rate should we use?

 

The answer should not come from another company’s proposal, a guess, or the rate that makes the budget look best on paper. The right indirect rate should reflect your company’s actual cost structure, your accounting system, your award strategy, and your ability to support the rate after award.

 

At Peter Witts CPA PC, we help SBIR/STTR companies strengthen their Phase II rate strategy so the proposal budget is realistic, defensible, and built for performance after award.

 

 

Why Indirect Rates Matter More in Phase II

Indirect costs are the general business costs needed to support the work but not tied to one specific project. These may include rent, payroll taxes, accounting, insurance, software, administrative labor, compliance support, utilities, and general management.

 

In Phase II, those costs often increase.

 

Companies may hire more employees, expand technical work, add consultants or subcontractors, strengthen accounting systems, increase insurance, improve timekeeping, and manage more complex reporting. If the indirect rate is too low, the company may not recover enough of the real cost of performing the work. If the rate is too high or unsupported, the proposal may raise questions.

 

The goal is not simply to choose the lowest rate or the highest rate. The goal is to choose a rate that is reasonable, supportable, and aligned with how the company will actually operate during the award.

 

 

The Indirect Rate Should Be Company-Specific

SBIR.gov explains that an indirect rate derived from indirect costs is unique to each company and tends to change over time, especially for small and startup companies.

That point matters.

 

A rate that worked for another company may not work for yours. A rate that worked during Phase I may not work for Phase II. A rate that looks competitive in a spreadsheet may not support the actual cost of managing the award.

 

Your indirect rate should reflect factors such as:

• Your current and projected payroll
• Your fringe benefit costs
• Your rent, utilities, and facilities costs
• Your administrative and management labor
• Your accounting, payroll, and compliance support
• Your software and systems
• Your insurance and professional fees
• Your direct labor base
• Your expected project mix
• Your growth plans during the award period

The rate should be built from your company’s numbers, not copied from someone else’s budget.

 

 

Start With the Agency Instructions

Before choosing a rate, start with the agency’s solicitation and budget instructions.

 

Different agencies may treat indirect costs differently. NIH, NSF, DOE, DoD, NASA, and other agencies may have different budget forms, thresholds, documentation expectations, rate options, and review processes.

 

Before preparing the Phase II budget, ask:

• Does the solicitation allow indirect costs?
• Does the agency provide a specific rate option or cap?
• Is a negotiated indirect cost rate agreement required or optional?
• Is a de minimis or simplified rate available?
• Does the agency require supporting documentation?
• Are fringe costs treated separately from overhead or G&A?
• Does the rate apply to salaries and wages, total direct costs, or another base?
• Are there excluded costs that should not be included in the base?
• Will the rate affect billing, reporting, or closeout after award?

The right rate strategy starts with the rules for the specific opportunity.

 

 

Understand the Main Rate Options

SBIR/STTR companies may encounter several indirect rate approaches depending on the agency, award type, and company history.

 

Common approaches include:

• A negotiated indirect cost rate agreement, often called a NICRA
• A de minimis rate, when permitted
• An agency-specific simplified rate
• A custom provisional or estimated rate
• Separate fringe, overhead, and G&A rates
• A combined indirect rate approach, when appropriate

There is no single best option for every company. The right approach depends on the agency instructions, the company’s financial records, the maturity of the accounting system, the award type, and the company’s ability to track and support the rate after award.

 

 

When a NICRA May Make Sense

A negotiated indirect cost rate agreement may make sense for companies with enough financial history, recurring federal work, or more mature accounting systems.

 

A NICRA can provide a formal basis for indirect cost recovery, but it also requires documentation, records, and consistency. It is not simply a rate request. The company needs financial data that supports the proposed rate structure.

 

A NICRA may be worth discussing if your company:

• Has prior federal awards
• Has historical cost data
• Expects multiple federal grants or contracts
• Has a stable accounting system
• Has clear cost pools and allocation bases
• Needs a formal rate for agency or award requirements
• Is preparing for more complex federal funding

For some early-stage SBIR/STTR companies, a NICRA may not be the first step. But understanding whether it is needed now or later can help leadership make better funding decisions.

 

 

When a De Minimis or Simplified Rate May Be Appropriate

Some agencies and award types may allow a de minimis or simplified indirect cost rate. This can be useful for companies that do not yet have a negotiated rate or extensive historical cost data.

 

However, using a simplified rate should still be a business decision, not an automatic choice.

 

A lower simplified rate may be easier to explain, but it may not recover enough of the real costs needed to perform the work. A permitted rate is not always the best financial rate for the company.

 

Before using a de minimis or simplified rate, ask:

• Is this rate allowed for this solicitation?
• Does it apply to the correct base?
• Does it cover enough of our actual indirect costs?
• Will it create cash flow pressure during Phase II?
• Will it support our staffing and compliance needs?
• Will it make sense if we pursue future awards?
• Can our accounting system track costs under this approach?

Simple does not always mean strategic. The rate should still support the company’s Phase II plan.

 

 

When a Custom Estimated Rate May Be Needed

A custom estimated rate may be appropriate when the company’s actual cost structure does not fit a simplified approach or when the agency allows applicants to propose a rate based on projected costs.

 

This can be common for growing SBIR/STTR companies because Phase II may change the business significantly.

 

A custom estimated rate should be supported by:

• Historical financial records, when available
• Projected payroll and staffing plans
• Fringe benefit assumptions
• Rent, software, insurance, and administrative costs
• Accounting and compliance support costs
• Direct labor or other allocation base assumptions
• Exclusion of unallowable costs
• Clear documentation of the calculation
• Alignment with the accounting system

A custom rate can be more accurate, but it also requires more support. The company should be ready to explain how the rate was developed and how it will be tracked after award.

 

 

Do Not Choose the Rate Just to Fit the Budget

One common mistake is choosing the rate that makes the proposal total fit the maximum award amount.

 

That approach can create problems.

 

If the indirect rate is reduced only to stay under the funding limit, the company may underrecover real business costs. If the rate is inflated to absorb unused budget, it may be difficult to support. If the rate is changed without adjusting the cost pools and allocation base, the calculation may not be defensible.

 

A better approach is to build the rate from the company’s cost structure, then review the full budget strategically.

 

If the total budget is too high, the company may need to revisit scope, staffing, consultants, materials, timing, or cost structure. The indirect rate should not be treated as a plug number.

 

 

Separate Fringe, Overhead, and G&A Thoughtfully

Some companies use one combined indirect rate. Others use separate fringe, overhead, and G&A rates.

 

The right structure depends on the company’s size, accounting system, cost patterns, and agency expectations.

 

A more detailed structure may help explain the company’s costs, but it also requires more discipline. Separate rates may require separate cost pools, allocation bases, reporting, and monitoring. A combined rate may be simpler, but it may not always reflect the cost structure accurately.

 

Before choosing a structure, consider:

• How payroll and benefits are tracked
• Whether facilities costs support direct labor
• Whether administrative costs support the whole company
• Whether cost pools can be separated consistently
• Whether the accounting system can support the structure
• Whether the team can maintain the process after award

The rate structure should be practical, not just technically correct.

 

 

Exclude Unallowable Costs

Unallowable costs should not be included in the indirect cost pool charged to federal awards.

 

This is an important part of rate strategy. A company may have legitimate business expenses that are not allowable under federal rules. Those costs should still be tracked, but they should be separated so they do not distort the indirect rate.

 

Common examples may include certain entertainment costs, alcohol, some lobbying costs, fines and penalties, and other costs restricted by the award terms or applicable cost principles.

 

Before finalizing the Phase II rate, review whether the indirect pool includes any costs that should be excluded.

 

 

Make Sure the Accounting System Can Support the Rate

A rate that looks good in the proposal can become a problem if the accounting system cannot support it after award.

 

The accounting system should be able to:

• Separate direct, indirect, and unallowable costs
• Track project costs by award
• Support direct labor and indirect labor
• Maintain cost pools and allocation bases
• Produce budget-to-actual reports
• Track actual indirect costs over time
• Support billing, drawdowns, or reimbursement requests
• Reconcile indirect costs to the general ledger
• Maintain documentation for review or audit

If the accounting system cannot track the rate, the company may struggle to support the budget during performance.

 

 

Consider Cash Flow and Cost Recovery

Indirect rate strategy is not only about compliance. It also affects cash flow.

 

If the rate is too low, the company may need to fund basic business infrastructure from outside sources. That can become difficult during Phase II when the company is scaling staff, managing technical work, and preparing for commercialization.

 

If the rate is too high or unsupported, it may create questions during review and may not be sustainable after award.

 

A strong Phase II rate strategy should help leadership understand:

• How much indirect cost the company expects to incur
• How much of that cost the award may recover
• Whether the company has funding gaps
• Whether administrative and compliance costs are covered
• Whether the rate supports growth
• Whether future awards will require a different structure

The goal is to support both proposal review and award performance.

 

 

Monitor the Rate After Award

Choosing the rate is not the end of the process.

 

During Phase II, the company should monitor actual indirect costs against the proposed or provisional rate. This helps leadership see whether the company is overrecovering, underrecovering, or drifting away from the assumptions used in the proposal.

 

Regular rate monitoring can help identify:

• Higher than expected payroll or fringe costs
• Changes in direct labor base
• New administrative costs
• Increased compliance or accounting support
• Facilities or software cost changes
• Unallowable costs that need to be excluded
• Budget pressure before it becomes a larger issue

A rate strategy should be managed throughout the award, not filed away after submission.

 

 

Common Phase II Indirect Rate Mistakes

SBIR/STTR companies often run into indirect rate problems because the rate is prepared too late in the proposal process.

 

Common mistakes include:

• Copying another company’s indirect rate
• Using the Phase I rate without reassessing Phase II needs
• Choosing the lowest rate to look competitive
• Using the highest rate to maximize the budget
• Not reviewing agency-specific instructions
• Treating the rate as a plug number
• Including unallowable costs in the pool
• Using an allocation base the accounting system cannot track
• Failing to document assumptions
• Not considering cash flow
• Not monitoring actual rates after award
• Building a rate structure that is too complex to maintain

These issues are easier to address before submission than after award performance begins.

 

 

Questions to Ask Before Finalizing Your Phase II Rate

Before submitting the Phase II proposal, ask:

• What rate options does the agency allow?
• Do we have a negotiated rate, or do we need another approach?
• Are we using historical costs, projected costs, or both?
• What costs are included in the indirect pool?
• What costs are excluded?
• Are unallowable costs separated?
• What allocation base are we using?
• Can our accounting system support the rate?
• Does the rate reflect our Phase II staffing and operations?
• Does the rate support cash flow and cost recovery?
• Can we explain the calculation clearly?
• Can we monitor the rate during the award?

These questions help make the rate part of a financial strategy, not just a budget line.

 

 

Final Thoughts: The Right Rate Should Support Both Submission and Performance

Choosing the right indirect rate for an SBIR Phase II proposal is not about finding a perfect number. It is about building a rate strategy that reflects the company’s actual cost structure, follows agency instructions, supports the proposal budget, and can be managed after award.

 

A strong rate should be reasonable, documented, and connected to the accounting system. It should help the company recover appropriate costs without creating avoidable review, billing, or cash flow problems later.

 

At Peter Witts CPA PC, we help SBIR/STTR companies strengthen Phase II indirect rate strategies so their budgets are built for both federal review and real-world performance.

 

 

Need Help Strengthening Your Phase II Rate Strategy?

If your company is preparing an SBIR/STTR Phase II proposal, Peter Witts CPA PC can help review your indirect rate approach, cost pools, allocation base, documentation, accounting system readiness, and post-award monitoring plan.

 

Backed by 35+ years of government contract accounting experience and first-hand DCAA knowledge, our team helps innovators build rate strategies that support proposal submission, award management, and long-term federal funding growth.

 

 

Schedule a strategic consultation with Peter Witts CPA PC to strengthen your Phase II rate strategy.