Cost allocation is the process of distributing an organization’s expenses across various programs or departments.
Proper allocation ensures expenses are reasonably and equitably charged across all programs and can help avoid potential audit issues. In addition, many grants and contracts require nonprofits to allocate indirect costs in accordance with specific guidelines.
Before discussing the indirect cost allocation process, let’s clarify what direct and indirect costs are. This is essential for the accurate allocation of indirect costs.
Direct vs. Indirect Costs
Direct costs are costs that can be identified with a particular cost objective, such as a federal award, external activity, or program, and can be directly assigned to those areas accurately. Direct costs can also be allocated to multiple cost objectives, which is not to be confused with indirect cost allocation. For example, an employee may spend their time administering two federal grants equally and their wages may be allocated directly to those grants proportionately.
Indirect costs are those costs that have been incurred for common or joint objectives and cannot be readily identified with a particular final cost objective. Indirect costs include items like administrative expenses, overhead, and facilities and IT expenses.
Best Practices for Indirect Cost Allocation
Regardless of whether a nonprofit organization is required to allocate indirect costs for federal awards, wants increased transparency and accountability, or for better financial decision making, the following best practices should be considered when developing a method.
Establish Clear Cost Pools — Begin by grouping your direct and indirect costs into clear categories. This step ensures that you have the appropriate costs included in the allocation.
Choose an Allocation Method — Select an allocation method that suits your organization’s size and complexity. Consider using an allocation base that will maximize the recovery rate of indirect costs.
Apply the Rate Consistently — Allocate indirect costs to each program based on the method on a consistent basis. This ensures fairness and comparability across all programs.
Document the Process — Maintain detailed documentation of your indirect cost allocation process. This documentation serves as evidence of compliance with grant requirements and can help avoid audit issues. Not having a written cost allocation plan is a common audit finding that nonprofit organizations receive.
Regularly Review and Adjust — Periodically review your allocation methods and rates to ensure they remain reflective of the underlying cost objectives being allocated to.
Indirect Cost Allocation Methods for Federal Awards
For allocating indirect costs to federal awards, there are several allowable methods nonprofit organizations may use which are described below.
Simplified allocation method — This method is best used for nonprofit organizations that have only one major function that crosses several projects or where the number of federal awards an organization manages is small. This consists of separating the organization’s total costs for the period as either direct or indirect and dividing by total allowable indirect costs by an equitable distribution base. This allows an indirect cost rate to be used for individual federal awards. The simplified method assumes that all direct activities benefit equally from all the administrative activities of the nonprofit organization.
Multiple allocation base method — This method is used most often by nonprofit organizations that perform different direct activities or functions and each activity receives administrative support in varying degrees. Indirect costs are separated into various pools and allocated to cost categories in the order determined to be most appropriate by the organization.
Direct allocation method — Some nonprofit organizations treat all costs as direct costs except general administration and general expenses. Under this method, indirect costs consist exclusively of general administration and general expenses and the organization’s indirect cost rate must be computed in the same manner as the simplified allocation method. It must be used by nonprofits that maintain accounts and financial statements in accordance with accounting requirements for voluntary health and welfare and comparable organizations.
Negotiated indirect cost rates — Nonprofit organizations can submit an indirect cost rate proposal to an identified cognizant federal agency. Upon review and approval of the proposal, the rate can be used to charge indirect expenses to all federal awards.
De minimus rate — Nonprofit organizations that do not have a current negotiated (including provisional) indirect cost rate are allowed to use a flat 10% rate for indirect costs charged to federal awards.
Managing federal awards comes with its own set of challenges, especially when it comes to allocating indirect costs. Regardless of complexity, indirect cost allocation is an essential practice for nonprofits seeking to manage their resources efficiently, maintain transparency, and fulfill grant requirements. The consequences of mismanaged indirect cost allocation can vary in severity from misallocation of resources to grant non-compliance and reputational damage. However, nonprofits can avoid these pitfalls by following best practices and specific guidelines. Through proper indirect cost allocation, nonprofits can make informed decisions while demonstrating accountability, allowing them to work toward achieving their missions effectively.