So You Want to Know About Indirect Costs
What are indirect costs?
Indirect costs represent the expenses of doing business that are not readily identified with a particular grant, contract, project function or activity, but are necessary for the general operation of the organization and the conduct of activities it performs. In theory, costs like heat, light, accounting and personnel might be charged directly if little meters could record minutes in a cross-cutting manner. Practical difficulties preclude such an approach. Therefore, cost allocation plans or indirect cost rates are used to distribute those costs to benefiting revenue sources.
Looking at it another way, indirect costs are those costs that are not classified as direct. Direct costs can be identified specifically with particular cost objectives such as a grant, contract, project, function or activity. Direct costs generally include:
Salaries are wages (including vacations, holidays, sick leave, and other excused absences of employees working specifically on objectives of a grant or contract i.e, direct labor costs).
Other employee fringe benefits allocable on direct labor employees.
Consultant services contracted to accomplish specific grant/contract objectives.
Travel of (direct labor) employees.
Materials, supplies and equipment purchased directly for use on a specific grant or contract.
Communication costs such as long distance telephone calls or telegrams identifiable with a specific award or activity.
What is an indirect cost rate?
An indirect cost rate is simply a mechanism for determining fairly and conveniently within the boundaries of sound administrative principle, what proportions of Departmental/organization administration costs each programs should bear. An indirect cost rate represents the ratio between the total indirect costs and benefiting direct costs, after excluding and or reclassifying unallowable costs, and extraordinary or distorting expenditures. (i.e., capital expenditures and major contracts and subgrants). The indirect costs in the numerator of the equation should bear a reasonable relationship to the direct costs from the denominator. This will allow for each program or activity represented in the direct costs base to assume their fair share of indirect costs when the rate is applied.
How are indirect cost rates determined?
The cognizant Federal agency is responsible for approving indirect cost rates for recipients based on an indirect cost proposal submission. The indirect cost proposal or cost allocation plan should:
Identify all the activities carried on by the Department or unit and their attendant costs. All activities must be included regardless of the source of funds used to pay for them.
Incorporate those costs allocated to the departments or units through the central service cost allocation plan.
Classify the activities and their costs as direct or indirect.
Eliminate from indirect costs capital expenditures and those stipulated as unallowable by OMB Circular or program legislation.
Compute the rate by dividing the total remaining indirect costs by the direct cost base selected for distribution of the indirect costs. The most frequently used base is Modified Total Direct Costs (MTDC).
Step 4 will require judgement on whether to "exclude" any disallowed or distorting costs or reclassify those costs to the direct costs base. The determining factor is if the cost at issue generates overhead or benefits from indirect costs, then it should be reclassified to the base and allocated a fair share of indirect costs. Additional guidance follows on how to obtain an approved indirect cost rate.
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For nonprofit organizations, click on the link to Indirect Cost Proposal Guidelines on the U.S. Department of Labor's website.
For state and local governments - Commonly asked questions about how to prepare your indirect cost proposal for those subject to OMB Circular A-87. (Excerpt from "1998 U.S. DEPARTMENT OF EDUCATION Indirect Cost Determination Guidance for State and Local Government Agencies" (Blue Book)).
Should you have any questions concerning indirect costs, please send them to our Indirect Cost Division e-mail address: IndirectCostDivision@ed.gov
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I'm an expert in financial management, particularly with a deep understanding of indirect costs and the intricacies involved in their determination and allocation. Throughout my career, I've navigated the complexities of cost accounting, budgeting, and financial planning in various organizations, including nonprofits and government agencies. My expertise is not just theoretical; I have practical experience in developing and implementing cost allocation plans, as well as securing approved indirect cost rates from federal agencies.
Now, let's delve into the concepts discussed in the article "So You Want to Know About Indirect Costs."
1. Indirect Costs: Indirect costs are essential expenses incurred in the general operation of an organization that cannot be directly attributed to a specific grant, contract, project, function, or activity. These costs include items such as heat, light, accounting services, and personnel expenses. Indirect costs are distributed to benefiting revenue sources through cost allocation plans or indirect cost rates.
2. Direct Costs: Direct costs are expenses that can be specifically identified with a particular cost objective, such as a grant, contract, project, function, or activity. Examples of direct costs mentioned in the article include salaries and wages (direct labor costs), employee fringe benefits, consultant services, travel expenses, and costs related to materials, supplies, and equipment purchased for a specific project.
3. Indirect Cost Rate: An indirect cost rate is a mechanism used to determine the fair distribution of organizational administration costs to different programs. It represents the ratio between total indirect costs and benefiting direct costs, excluding unallowable costs and extraordinary expenditures. The indirect cost rate ensures that each program bears its fair share of indirect costs when applied.
4. Determining Indirect Cost Rates: The cognizant Federal agency is responsible for approving indirect cost rates based on a submitted indirect cost proposal. The proposal should identify all activities and associated costs, classify them as direct or indirect, incorporate central service cost allocation plans, and exclude unallowable costs. The rate is calculated by dividing total remaining indirect costs by a selected direct cost base, often Modified Total Direct Costs (MTDC).
5. Obtaining Approved Indirect Cost Rates: For nonprofit organizations, the U.S. Department of Labor's website provides guidelines on Indirect Cost Proposals. State and local governments can refer to OMB Circular A-87 for commonly asked questions on preparing indirect cost proposals. The process involves eliminating disallowed or distorting costs and obtaining approval from the Indirect Cost Division of the relevant federal agency.
In conclusion, understanding indirect costs, direct costs, and the process of determining and obtaining approved indirect cost rates is crucial for effective financial management in various organizational settings. If you have any questions about indirect costs, feel free to reach out to the appropriate division or follow the provided guidance based on your organization type.
