By Judy Monteux, RCAC financial management specialist
Part I: That which is not direct
Are you afraid that when your funders see the line item “indirect cost,” they will have a negative reaction? Are you puzzled by the difference between indirect costs and administrative costs?
Have you adjusted your proposal budgets to fund indirect costs without calling them indirect costs?
That which is not direct—that is about as clear a definition of indirect costs as many people will find in their quest to understand the difference between direct and indirect costs. Indirect costs are one of the most confusing, misunderstood and controversial concepts in nonprofit financial management. Terms like “administrative costs,” “overhead” and “indirect” are often used interchangeably when they can represent very different things.
Let’s look at the definitions of these often confusing terms:
- A direct cost is an expense whose benefit can be specifically identified with a particular funding source and/or program.
- A shared or common direct cost is an expense whose benefit can be specifically identified with more than one funding source or program.
- An indirect cost is a shared cost whose benefit is not readily identifiable with a specific program or programs but is necessary to the general operation of the organization. Some typical indirect costs include some percentage of the salaries of the executive director and accounting staff, the annual audit and other accounting fees, general liability and directors and officers’ insurance and board travel expenses. Indirect costs can be allocated individually by line item (e.g. “board expense” or “audit”) or accumulated in a single indirect pool and expensed as one line item (“indirect expense”) using some kind of indirect rate.
- Administrative cost – Up until the publishing of the July 2017 FAQs by the Council on Financial Assistance Reform (COFAR), there was no definition of “administrative costs “in the Uniform Guidance even though some federal statutes limit administrative costs to a certain percent of the total award. The FAQs finally address the issue of indirect versus administrative costs although they stop short of a clear definition:
200.56 – .56-1 Indirect Costs v. Administrative Costs
Federal statutes usually do not have a cap on indirect costs, but sometimes have a cap on administrative costs. Are indirect costs and administrative costs the same thing? Yes they can be, but it depends on the treatment of the costs. The term administrative is broad and it encompasses the indirect and direct portions of administrative cost. Therefore, the difference is whether the administrative support efforts can be identified directly or indirectly to cost objective. These costs can be both personnel and non-personnel, and both direct and indirect.
- Overhead cost – For nonprofit organizations, overhead is generally defined as a combination of “Fundraising” expenses (costs that involve seeking, soliciting, or securing charitable contributions) and “Management and General” expenses (all the other costs that are needed to operate the organization and are shared across programs) according to the instructions for the IRS Form 990 (the federal tax return for nonprofit organization). These categories are used along with program expenses in a nonprofit independent audit report and on the annual IRS Form 990.
Assume that you are the executive director of a small nonprofit organization that has recently received funding to add an after-school activity program for troubled teens to the counseling services that you already provide. You hire a part-time staff person to coach a weekly basketball clinic and a consultant to teach a weekly course on scrap booking. You rent the high school gym for two hours a week. The gym contains a small room located next to the basketball court that you can use for the crafts activities. Let’s look at how to categorize the costs related to these new programs.
|Line Item||Direct Cost – 100%||Shared Direct Cost||Indirect Cost||Administrative Cost||Overhead Cost|
|Salary – Part-time basketball coach||X|
|Salary -counseling program manager (Manages after school programs and provides direct service to clients.)||X||X|
|Basketballs for clinic||X|
|Salary – accountant||X||X||X|
|Office rent and utilities||X||X||X||X|
|Cell phones (all staff have one)||X||X||X||X|
|Fundraising event expenses||X|
- 100 percent direct – When you purchase basketballs for the after-school clinic or scrapbooking supplies for the crafts class, it is easy to see why these would be charged as 100 percent direct costs to that program. In the same way, the salary and fringe and consulting fees for staff who were hired to only run that program would be 100 percent direct costs.
- Shared direct costs – The cost of the gym rental would be a direct cost that is shared among the two new programs. The counseling program manager’s salary and related fringe benefits benefit direct programs but some of that time is program administration, which is considered administrative costs even though it is a direct cost to the program. Therefore it is marked as direct and administrative costs.
- An indirect cost – The organization’s accountant does not teach basketball and yet, without this service as well as the corporate insurance, the organization could not operate.
- Administrative cost –As demonstrated in the table above, administrative costs could be direct or indirect. In this example, they include the allocation of the accountant salary and fringe benefits, the program manager salary and fringe benefits, office rent and utilities, corporate insurance, cell phones, postage.
- Overhead cost – Shared operating direct costs that are considered overhead like rent, utilities, phones and postage benefit all programs and could be allocated directly or included in an indirect pool. Other overhead costs include those associated with soliciting contributions and fundraising events.
If your organization provides one service to the community and is funded by one grant award, your tracking needs are simple. All of your expenses benefit that one funding source and that one program so they would all be charged directly. As soon as you add another program and/or funding source, you will have to determine which costs are direct, which costs are shared direct and which costs are indirect as well as how to charge each of these programs and funding sources for the expenses that occur. You could always have a separate accountant, corporate liability insurance, audit, board meeting, fidelity bond, and D&O insurance policy for each of your funding sources/programs! Obviously, this would not be cost effective or practical but it would certainly provide each funding source an accurate accounting of the cost of these expenses for each one.
Short of the above scenario, how is an organization to prorate and charge its funding sources for all of the shared costs, both direct and indirect, associated with running the organization? “We charge everything directly” is a response I often hear. That’s great, but how do you decide how much each program or funding source will pay “directly” for all the costs that are shared? These shared costs may include office supplies, rent, audit, telephone, printing and copying, utilities and salaries as well as all of the indirect costs for the organization. It all comes down to fair and equitable allocation of these essential costs, which should be documented in a written, approved cost allocation plan that outlines your organization’s methodology for allocating these costs.
THE COST ALLOCATION PROCESS
Allocation of shared costs (direct and indirect) to appropriate funding sources is a multiple-step process:
- Those costs that can be 100 percent charged to any programs/funding sources and those that will be allocated 100 percent to the indirect pool (to be spread across funding sources in a later step) should be coded directly to those funds/cost centers.
- Those costs that are incurred for common or joint purposes should be accumulated monthly in a pool or department in the accounting system. For example, throughout the month, all office supply invoices that reflect purchases for general use would be charged to the line item “office supplies” and to a generic department (perhaps “allocated costs”) rather than specific funding sources. At the end of each month, each of the line items in this generic department must be distributed as an expense to all appropriate funding sources, including the indirect cost pool if you have one, using an approved cost base.
- The organization’s indirect costs must then be spread across all appropriate funding sources. If you are using an indirect pool, these costs would be allocated using the cost base you have chosen for this pool and the expense will appear in the indirect expense line item for each funding source. If you are allocating each indirect cost directly by individual line item, you will use the cost base you have chosen for each indirect line item (i.e., a portion of the audit expense will show on the line item called audit expense for each appropriate funding source).
Let’s look at what this would mean for the organization described above:
- All non-shared costs that specifically benefit only one program are charged to the appropriate funding source throughout the month. In the example above, the cost of scrapbook paper and glue would be directly charged to that program’s funding source.
- At the end of the month, you must identify those direct costs that benefited more than one program and charge them out based on the cost base you decided would result in the most equitable distribution of the expense. In the case of the rent of the gym, the expense is shared by both programs. Since they both use the space for the same amount of time, it would be fair to use the percentage of total square footage used by each program as the cost base to allocate the rent of the gym for the month. Other typical monthly shared general operating expenses that must be allocated may include postage, telephone, office rent, utilities and office supplies.
- Finally, the appropriate percentage of the organization’s indirect costs must be allocated to these programs at the end of each month.
The table below lists common shared costs and some typical cost bases that are used to allocate them. Note that this is not a complete list. You may choose any cost base that results in an equitable and consistent allocation of costs.
|Line Item/Pool||Cost Base(s)|
|Salaries||Time sheets showing actual time charged to programs|
|Board travel||% of revenue OR % of salaries|
|Supplies||% of salaries|
|Telephone (basic)||# of instruments|
|Postage||Postage meter OR % of salaries|
|Copying||Copy log OR % of salaries OR # of full time equivalents (FTE’s)|
|Accounting/audit||# of transactions|
|Indirect pool||Direct salary and fringe OR Total or Total Modified direct costs|
Each cost base you choose must meet the following guidelines:
- The cost base must be reasonable and consistently applied. You can’t guess or use budgeted amounts. In addition, you can’t allocate to a funding source just because it has more available funds than other grants or contracts.
- Choose each cost base using accurate and current data to determine its reasonableness. All of your cost bases should be re-evaluated periodically to ensure that they result in a fair and equitable distribution of shared costs.
- The cost base must be appropriate to the cost. For example, the number of telephone instruments would not be an appropriate cost base to use to allocate fringe benefits.
- The cost base you choose should result in an accurate measure of the benefit each program/funding source receives from each shared cost. This does not mean that it will be an exact measure of the benefit but rather a fair and equitable distribution. As long as you implement your approved cost allocation plan for all funding sources throughout the year, the funding sources including your federal funders will be satisfied that they are paying no more and no less than their fair share.
Several years ago, the Office of Inspector General (OIG) of the Department of Labor reviewed the cost allocation practices of federally funded organizations and found a number of common problems. The most common problem involved the lack of documentation of salary costs. Many organizations used timesheets as documentation for payroll expenses, but the timesheets only reflected the number of hours each employee worked, and not the allocation of those hours across various funding sources. Time sheets serve as the base for allocating salaries and wages and must reflect the distribution of labor costs among multiple funding sources. Hours charged to funding sources on timesheets must match the way in which those hours were charged to the organization’s funding sources or those expenses can be disallowed.
The issue of undocumented expenses came up as well when OIG reviewed travel expenses. If an organization is going to charge a funding source for travel-related costs, those costs must be documented to show how the travel was related to the program. Travel documentation should include forms that show authorization to travel prior to the date of the trip. Organizations should also use specific travel reimbursement forms to which receipts for travel costs are attached once the trip has been completed.
OIG also discovered that organizations were including unallowable items in the cost pools that were allocated across all funding sources including federal grants. In one instance, board meeting snacks and lunches were recorded as indirect costs and included in the indirect pool. These costs were later disallowed and had to be repaid.
Another common allocation mistake many organizations make is the way they treat credits received on overpaid bills. If you receive a refund from an overpayment of an expense and the expense was originally expensed at least in part to a federal grant, the federal government expects that it will receive its fair share of the refund. Many organizations make the mistake of recording this refund as unrestricted revenue but it should instead be used to reduce the current year’s expense.
There is no time like the present to re-examine your organization’s cost allocation policies. Don’t make the mistake of using unrestricted funds or general funds for allowable costs that should really be borne by the grants that fund your operations. Make sure that all of your sources of funds and programs are paying their fair share of the costs that are necessary to continue to serve your clients.
Save those hard earned unrestricted funds to pay for new programs, capital expenditures or federally unallowable costs!
Part II: Indirect costs and the uniform guidance—what’s new?
Does your organization struggle to get your federal grants to cover any overhead costs directly or indirectly? Does your organization have a negotiated indirect cost rate that has to be renegotiated every fiscal year? The new Uniform Guidance has some good news for you—there are new ways to recover indirect costs from your federal awards!
Title 2 CFR 200 was implemented by all federal agencies on December 19, 2014. The new regulations consolidated eight OMB Circulars, including the Circulars that governed direct and indirect costs (A-122 and A-87), into one location in the Code of Federal Regulations (www.ecfr.gov). These streamlined and revised regulations include some changes to the calculation and application of indirect costs to federal awards. (See Section 200.414 of Subpart E – Cost Principles):
- If your organization has never negotiated an indirect cost rate agreement, you may elect to use a de minimis rate of 10 percent of modified total direct cost (MTDC) without negotiating that rate with a cognizant agency. It is important that your organization calculate whether or not that 10 percent rate would be sufficient to cover your indirect costs. This rate must be applied to all of your federal awards. Your organization can continue to use this rate until your organization chooses to negotiate for a rate, which you may apply to do at any time.
- Many organizations have struggled to cover their indirect costs because some or most of their federal awarding agencies or passthrough entities did not accept their negotiated indirect cost rate. The Uniform Guidance contains specific language that requires federal awarding agencies and passthrough entities (See Section 200.331) to accept a recipient or sub-recipient’s negotiated indirect cost rate including the new de minimis rate. The bad news is that there is still an exception to this new regulation that states that if the federal statute or regulation governing those funds limits or disallows indirect costs/administrative costs, your organization may not be able to recoup all of the indirect costs that would apply to the federal award.
- There is some good news even when you cannot collect 100 percent of your negotiated indirect cost rate from a federal award. You may be able to use those unrecovered indirect costs toward all or part of your cost sharing or match for any federal award. (Unrecovered indirect cost means the difference between the amount charged to the federal award and the amount which could have been charged to the federal award under the non-federal entity’s approved negotiated indirect cost rate.) You will need the prior approval of the federal awarding agency to do this. (See Section 200.306(c) – Cost Sharing or Matching in 2 CFR 200.)
- If your organization has negotiated a final rate with your cognizant agency (your largest federal funding source), you may elect to extend that rate for up to 4 additional years without negotiation. Those extended rates basically become fixed rates for that extension period so make sure that you are comfortable with the rate you request to extend. You will not be able to request a rate review until the extension period ends. At the end of the extension period, the cognizant agency will negotiate a new provisional rate based on the audited financials for the last year of the extension period but no renegotiation of the rate for that last extended year will take place. Your organization can request this extension each time a new final or predetermined rate has been awarded. This extension is not available to organizations that have a fixed rate with a carry forward.
- If your organization is a “major” nonprofit (you received more than $10 million dollars in direct federal funding), your indirect cost pool will have to be split into two pools – “Facilities” and “Administration.” “Facilities” is defined as depreciation on buildings, equipment and capital improvement, interest on debt associated with certain buildings, equipment and capital improvements, and operations and maintenance expenses. “Administration” is defined as general administration and general expenses such as the director’s office, accounting, personnel and all other types of expenditures not listed specifically under one of the subcategories of “Facilities”.
- The requirements for development and submission of indirect (F&A) cost rate proposals and cost allocation plans for a variety of types of non-federal entities can be found in Appendices III-VII.
USING THE DE MINIMIS RATE
As mentioned above, if your organization has never negotiated an indirect cost rate (NICRA) with a cognizant agency, you may elect to use the 10 percent of Modified Total Direct Cost (MTDC) de minimis indirect rate to recover indirect costs as part of your federal grant budgets.
- How to elect it? All you need to do is to send a letter on letterhead signed by an authorized signer from your organization to each of your federal funding sources stating that your organization is electing the 10 percent de minimis indirect rate. In the letter, you will also need to certify that your organization has never had a NICRA, and that your organization will apply this rate to all of your federal grants.
- How is an indirect cost rate calculated? An indirect cost rate is calculated by simply dividing your pool of total indirect costs for your fiscal year by some cost base. For example, if you have a pool of indirect costs of $150,000 and a direct base of $1,000,000, your indirect cost rate for that fiscal year would be 15 percent ($150,000/$1,000,000). For every dollar of that base you spend, you could draw down $1.00 plus 15 percent of that $1.00 or $ 1.15.
- What is MTDC? If you elect to use the 10 percent de minimis rate, the Uniform Guidance requires that you use Modified Total Direct Costs as the cost base. The definition can be found at 68 Modified Total Direct Cost (MTDC): MTDC means all direct salaries and wages, applicable fringe benefits, materials and supplies, services, travel, and up to the first $25,000 of each subaward (regardless of the period of performance of the subawards under the award).
The term “Modified” refers to certain exclusions of costs that must be removed from the total direct costs before the 10 percent indirect rate is applied to each funding source. According to the Uniform Guidance, the costs to exclude are equipment, capital expenditures, charges for patient care, rental costs, tuition remission, scholarships and fellowships, participant support costs and the portion of each subaward in excess of $25,000. Other items may only be excluded when necessary to avoid a serious inequity in the distribution of indirect costs, and with the approval of the cognizant agency for indirect costs.
Please note – “rental costs” do NOT mean rent and utilities that are part of the overhead costs of the organization. (For clarification, see the July 2017 COFAR FAQs .68-3 Are Rental Costs Allowable Costs?)
- How do I know if this rate is right for my organization?
The first step is to examine your current cost allocation methodology which should be documented in an approved cost allocation plan to review how your organization is currently funding its “indirect” costs. As mentioned at the conclusion of Part I of this series, many not-for-profit organizations end up using their hard earned unrestricted or “administrative” funds to pay for indirect costs because their funders limit the amount of administrative costs that can be charged or the organization makes a choice to limit charging those costs in order to maximize the direct program funding. The latter is admirable but may cause underfunding of the infrastructure of your organization. Even the federal government is finally acknowledging the importance of funding a fair share of running your organization itself, not just its programs.Step 2 is to calculate what your organization’s indirect rate would have been if you had used that methodology in the past. Using your most current audited financials, pull out all of the costs that would qualify as indirect including some portion of the ED’s salary and fringe, corporate insurance, etc. You might also include the total rent, utilities, corporate office supplies and other overhead costs that could be allocated directly including a portion to the indirect pool or could all be included in the indirect cost pool. Determine the total indirect cost pool and divide that total by what would have been your Modified Total Direct Costs for that fiscal year. This will give you an estimated indirect cost rate for that year. Is it 10 percent or close? That percentage will be in part determined by the decision of what overhead costs are included in the indirect pool. Your organization has a choice of how to deal with the general overhead costs.
- How to implement it? The de minimis rate is a fixed rate, just like predetermined indirect rates or even like GSA per diem rates. Your organization does not have to negotiate or justify the 10 percent rate to a cognizant agent but your organization must ensure that costs to be covered by the indirect rate are not also charged directly to the grant. For example, if in the past you have allocated your general liability insurance across all of your funding sources using the insurance expense line item, you cannot continue to do that and also collect the 10 percent de-minimis since that expense would typically be part of the indirect pool.Your accounting department should create a separate cost center for indirect in your accounting software and code true indirect costs 100 percent to this cost center. This cost center should receive its own allocation of other shared direct costs depending on the cost base for each of those costs. For example, if you allocate your office supplies based on the percentage of salaries and fringe benefits charged to each cost center, then indirect should be charged it share based on any indirect salaries and fringe benefits charged to the indirect cost center. Then, at the end of each month, after all shared direct costs have been allocated across all appropriate funding sources, your organization should review the direct costs to ensure that none have to be excluded from the base. Then the 10 percent indirect rate would be applied to the remaining total direct costs for the month as a debit to the indirect cost expense for each funding source. The credit portion of that entry would be to the indirect line item in the indirect cost center, resulting in a negative number.
- What if our calculated indirect rate is below 10 percent of MTDC for the fiscal year?
As mentioned above, the 10 percent de minimis rate added to federal regulations with the implementation of the Uniform Guidance in 2014 is a fixed rate. When using the de minimis rate, no documentation is required, but auditors are expected to review costs to ensure they are allowable, not double charged, treated consistently in similar circumstances, etc. There are some government entities that may try to require documentation of the de minimis rate, even though this is not correct. The July 2017 COFAR FAQ that addresses this:
.414-12 Providing Proof of Indirect Costs for De Minimis Rate
Does a non-federal entity that uses the 10 percent de minimis indirect cost rate need to provide documentation to prove that its indirect costs are at least 10 percent of its organization’s modified total direct costs?
No. A non-federal entity that has never received a negotiated indirect cost rate and that uses the 10 percent de minimis rate does not need to provide proof of its indirect costs. The 10 percent de minimis rate was designed to reduce burden for small non-federal entities (See also .414-11 above). The non-federal entity has to report in its SEFA whether it has elected to use the 10 percent de minimis rate for its federal programs (see §200.510(b)(6)).
On the other hand, 10 percent of MDTC is already a very small number. If your organization’s indirect rate is less than that, you may not be fully accounting for or funding the critical organizational costs to run your organization. Is your organization doing without needed staff positions and/or computer systems necessary to be effective and efficient?
- What if my federal funds have a cap on Administrative costs?
According to the July 2017 COFAR FAQs, any limitation or statutory cap on administrative costs applies to the combined claims for indirect costs and direct administration costs. (See 200.56-1 Indirect Costs v. Administrative Costs) As a result, your organization may not be able to collect the full 10 percent de minimis indirect charge from the award.
The first step is to calculate the two amounts since the cap applies to the full grant amount while the 10 percent de minimis is applied only to the MTDC. For example, if an organization receives a $100,000 federal grant with a 5 percent admin cap, there would be $5,000 available for direct and indirect admin. However, the 10 percent de minimis indirect charge to that grant (assuming there were no exclusions to make from the direct costs) would be $9,091 ($100,000 divided by 1.1 x 10 percent), not $10,000 (10 percent of the $100,000). Obviously the grant would not pay its full share of the 10 percent but the difference would be a little less than the difference between $10,000 and $5,000.
Step 2 is to determine whether or not your organization can find the administrative funds to cover the under collection of these admin costs. This should be part of the discussion before your organization applies for or accepts this award.
If your organization decides to accept this grant with its administrative cap, the full amount of the de minimis indirect rate should be calculated and charged to the grant internally so that management will know the true cost of the program even though your organization will not be able to draw the full cost down from the grant.
- Auditing the 10 percent indirect de minimis rate
The OMB Compliance Supplement referenced in Appendix of the Uniform Guidance provides auditors conducting a single audit or federal program audit with guidance on auditing the 10 percent de minimis indirect rate. The audit objectives found on page 3.2-B-11 of the July 2017 Compliance Supplement include the following:
- Obtain an understanding of internal control, assess risk, and test internal control as required by 2 CFR section 200.514(c).
- Determine that the de minimis rate is applied to the appropriate base amount.
- Determine that the de minimis rate is used consistently by a non-federal entity under its federal awards.
The Supplement also includes suggested compliance audit procedures for the de minimis indirect cost rate which apply to any non-federal entity using a de minimis indirect cost rate, whether as a recipient or subrecipient. The auditor should determine that the non-federal entity has not previously claimed indirect costs on the basis of a negotiated rate for the 3 fiscal years immediately prior to the current audit period. In addition, the auditor should test a sample of transactions for conformance with 2 CFR section 200.414(f). This would include a sample of claims for reimbursement of indirect costs and verify that the de minimis rate was used consistently, the rate was applied to the appropriate base, and the amounts claimed were the product of applying the rate to a modified total direct costs base. Finally, for a non-federal entity conducting a single function, which is predominately funded by federal awards, the auditor should determine whether the use of the de minimis indirect cost rate resulted in the non-federal entity double-charging or inconsistently charging costs as both direct and indirect.