FAR 42.707—Cost-sharing rates and limitations on indirect cost rates.
Plain-English Summary
FAR 42.707 explains when and how the Government may use indirect cost rate ceilings in contracts. It covers two main situations: cost-sharing arrangements, where the contractor agrees to absorb part of the cost by accepting indirect rates below anticipated actual rates, and other cases where a final indirect cost rate ceiling is prudent because of the contractor’s circumstances. The section also identifies examples that justify a ceiling, including a new or recently reorganized company with no reliable indirect cost history, a contractor with rapidly rising indirect rates due to declining sales, and a contractor that proposes unrealistically low rates to win a competition and then risks a cost overrun. In practice, this provision lets contracting officers manage risk by capping reimbursement exposure while still allowing the parties to negotiate an equitable arrangement. It also makes clear that if a ceiling is used, the contract must state both that the Government will not pay above the ceiling and that lower actual final rates will replace the ceiling. This section is especially important in cost-reimbursement and cost-sharing environments because indirect rate assumptions can materially affect price, reimbursement, and contractor financial exposure.
Key Rules
Cost-sharing may use lower rates
When cost sharing is authorized, the contractor may participate in contract costs by accepting indirect cost rates below its anticipated actual rates. The contract may include a negotiated indirect cost rate ceiling that applies prospectively.
Ceilings may be prudent in other cases
A final indirect cost rate ceiling may also be appropriate outside cost-sharing when the contractor’s situation makes actual future rates uncertain or likely to rise. FAR identifies new or recently reorganized firms, firms with rapidly increasing indirect rates, and firms proposing unrealistically low rates as examples.
Equitable ceiling must be negotiated
If a ceiling is used, it must be fair and negotiated based on the circumstances. The ceiling is not automatic; it should reflect a reasonable allocation of risk between the Government and the contractor.
Government pays no more than ceiling
The contract must state that the Government has no obligation to pay additional amounts if final indirect cost rates exceed the negotiated ceiling rates. This protects the Government from upward adjustments above the cap.
Lower actual rates replace ceiling
The contract must also provide that if the final indirect cost rates are below the ceiling, the lower actual rates control. The contractor does not get to retain the benefit of a higher ceiling when actual rates come in lower.
R&D cost sharing cross-reference
For cost sharing in research and development contracts, the section points to FAR 35.003(b). That cross-reference signals that special R&D cost-sharing rules may apply in addition to this general indirect rate guidance.
Responsibilities
Contracting Officer
Determine whether a cost-sharing arrangement or indirect cost rate ceiling is appropriate, assess the contractor’s risk profile and rate history, negotiate an equitable ceiling when justified, and ensure the contract includes the required ceiling language.
Contractor
Propose realistic indirect cost rates, disclose relevant historical and projected rate information, accept the negotiated ceiling if included, and understand that reimbursement will be limited to the ceiling unless actual final rates are lower.
Agency
Apply policy consistently, support contracting officers in evaluating whether ceilings are prudent, and ensure contract files document the rationale for using a ceiling and the basis for the negotiated terms.
Auditors/Cost Analysts
Review indirect cost data, help assess whether proposed rates are reasonable, and support the contracting officer in identifying situations where a ceiling may be needed to prevent overpayment or cost growth.
Practical Implications
This section is mainly about managing uncertainty in indirect rates, so it matters most when a contractor’s overhead, G&A, or other indirect pools are hard to predict.
A common pitfall is using a ceiling without a solid factual basis; the ceiling should be tied to the contractor’s history, structure, or proposal behavior, not used as a default bargaining tool.
Another risk is failing to include the required contract clauses or clear language, which can create disputes over whether the Government is capped and how lower final rates are handled.
Contractors should be careful not to understate indirect rates just to win work, because if a ceiling is imposed they may absorb overruns and reduce profit or create losses.
Contracting officers should document why the ceiling is equitable and how it relates to the expected performance period, especially for new firms or firms with volatile indirect cost trends.
Official Regulatory Text
(a) Cost-sharing arrangements, when authorized, may call for the contractor to participate in the costs of the contract by accepting indirect cost rates lower than the anticipated actual rates. In such cases, a negotiated indirect cost rate ceiling may be incorporated into the contract for prospective application. For cost sharing under research and development contracts, see 35.003 (b). (b) (1) Other situations may make it prudent to provide a final indirect cost rate ceiling in a contract. Examples of such circumstances are when the proposed contractor- (i) Is a new or recently reorganized company, and there is no past or recent record of incurred indirect costs; (ii) Has a recent record of a rapidly increasing indirect cost rate due to a declining volume of sales without a commensurate decline in indirect expenses; or (iii) Seeks to enhance its competitive position in a particular circumstance by basing its proposal on indirect cost rates lower than those that may reasonably be expected to occur during contract performance, thereby causing a cost overrun. (2) In such cases, an equitable ceiling covering the final indirect cost rates may be negotiated and specified in the contract. (c) When ceiling provisions are utilized, the contract shall also provide that- (1) The Government will not be obligated to pay any additional amount should the final indirect cost rates exceed the negotiated ceiling rates, and (2) In the event the final indirect cost rates are less than the negotiated ceiling rates, the negotiated rates will be reduced to conform with the lower rates.