Calculating Indirect Cost Rates

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This Issue's Question: How do you determine and negotiate an indirect rate for a federal grant?

Answer: In a multi-program organization, all costs can be divided into two different types: direct and indirect. Direct costs are those that are clearly and easily attributable to a specific program. For example, the cost of new basketballs is clearly related to the after-school athletics program. Similarly, it is easy to justify charging counselors salaries to the counseling program.

Indirect costs are those that are not easily identifiable with a specific program, but which are, nonetheless, necessary to the operation of the program. These costs are shared among programs and, in some cases, among functions (program, management and general, and fundraising). The executive director's salary is a common example of an expense that benefits all programs and functions. Other indirect, or shared, costs may include rent, telephone, postage, printing and other expenses that benefit all programs and functions of an organization.

Why Allocate Indirect Costs to the Programs? The full cost of a program rightfully includes a share of the overall costs of the organization. Knowing the full cost of a program sets a basis for financial analysis of the program, for pricing fee-based services, and for requesting reimbursement from funders for the full costs of providing services.

What Are the Methods for Allocating Indirect Costs? There are several methods for allocating indirect costs. The two most common are case-by-case allocation and developing an indirect cost rate.

Case-by-Case Allocation. One method of allocating indirect costs is to determine a rate of actual usage for each program. For example, you may decide to keep track of long distance telephone calls and charge them to the appropriate program when you pay the phone bill each month. Similarly, some organizations use a counter or log to track copying expenses for each program and/or function. Time sheets may form the basis for allocation of salaries for the executive director, accountant, and staff whose work benefits more than one program or activity. A different method can be adopted for each line item or case.

The advantage of this method is that it seems to "make sense." A major disadvantage, however, is that it often requires a great deal of time-consuming record-keeping. Even if you keep the records needed to precisely allocate shared expenses among programs, not all expenses will be covered. If, for example, the rent is allocated by square feet, how should you allocate the hallway and rest rooms? What about the local phone calls which cannot be tracked using a code?

For those shared expenses which cannot easily be divided directly into programs and functions, an indirect cost rate is useful.

Developing an Indirect Cost Rate. The first step in determining an indirect cost rate is to separate all costs into two groups: direct and indirect costs. The indirect costs are aggregated into an indirect cost "pool" and then allocated to the programs based on a set proportion or rate.

There are several measures used to determine the proportion of indirect costs to allocate (apply) to each program. The following simple example illustrates an indirect cost rate based on the relationship between total indirect costs and total direct costs:

Example 1-- The Tadpole League
The Tadpole League has a total budget of $3,300. The budget is distributed as follows:
Program A has direct costs of $1,000
Program B has direct costs of $2,000
Indirect costs to run the programs is budgeted at $300
Total costs are $3,300

Since Program A's direct costs are one-third of the total direct costs of the agency ($1,000 out of $3,000), it should bear one-third of the indirect costs. Similarly, since Program B incurs two-thirds of the total direct costs of the agency, it should bear two-thirds of the indirect costs, as well.

The Tadpole League can create an indirect cost rate which will allow it to easily accomplish this allocation. An indirect cost rate (using direct costs as a base) is established by dividing the total indirect costs by the total direct costs. For the Tadpole League the indirect cost rate is:

Total Indirect Costs divided by Total Direct Costs = $300/$3,000 = 10 percent of total costs

Each program's share of indirect costs can be calculated as a proportion of its direct costs:
Program A Indirect Expenses: $1,000 x 10% = $100
Program B Indirect Expenses: $2,000 x 10% = $200
Total Indirect Expenses = $300

After the indirect costs have been allocated to the programs, the budget now reads as follows:
Program A has direct costs of $1,000, indirect costs of $100 = $1,100
Program B has direct costs of $2,000, indirect costs of $200 = $2,200
Total costs are $3,300

This illustrates that after Program A has picked up its fair share of indirect costs, the true cost of running Program A is $1,100. As you can see from this example, using direct costs as a basis for your indirect cost rate will result in larger programs being charged with more of the indirect costs than smaller programs.

Is There More Than One Way to Calculate an Indirect Cost Rate? The Office of Management and Budget Circular A-122, Cost Principles for Nonprofit Organizations, describes the method of developing a federal indirect cost rate, using these same principles. To apply for a federal indirect rate, refer to the link at the bottom of this page.

However, even within these guidelines, indirect cost rates for the same organization may vary from federal agency to federal agency. Organizations may allocate indirect costs based on how many people are served in each of their programs, how large each of their sites is, or other logical methods.

What Is the Standard for Allowable Indirect Costs? There is little agreement in the nonprofit or funding community about how to calculate the rate, what to include, and how much is fair. There are no across-the-board standards or maximum levels for indirect costs. Some foundations have informal, unwritten guidelines for a maximum level. Under federal guidelines, allowable indirect costs range from 3 percent to 70 percent, varying from agency to agency.

Contrary to popular belief, indirect costs are not an easy measure of an organization's efficiency or stewardship. For example, imagine a multi-service agency where each program has its own bookkeeper, purchases its own supplies, and has all its own equipment. Such an organization would have no indirect costs at all, but would be clearly less efficient than if the programs shared bookkeeping costs, supplies and equipment.

Final Comments. Because the presentation of financial information influences the way we assess an agency's finances, the selection of indirect costing methods and accounting procedures has an important impact on decision-making. Several urgent and perhaps conflicting demands are made of the indirect costing process: to attribute indirect costs in the fairest way possible, to attribute the most indirect costs to the programs that can best afford them, to eliminate as many indirect costs as possible by having each program buy its own supplies, etc. Finding a balance among these demands that clears confusion and informs decision-makers is a responsibility of all participants in the nonprofit sector.

Other Important Resources

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Calculating Indirect Cost Rates