Developing a fair and equitable indirect cost allocations process is key to proper nonprofit financial management and reporting.
Nonprofit Expense Classification
All nonprofit organizations need to classify their expenses in one of three functional areas:
- Management and General (Administration)
- Programs (Mission)
- Fundraising (cost of raising funds)
Most expenses are easily identified as ‘direct costs’ to one or more of these areas, but other expenses cannot be easily identified and expended to a specific program, so they are posted to ‘cost pools’ to be allocated (distributed) to the functional areas that these expenses benefit.
Developing a fair and equitable nonprofit cost allocation process is key to proper financial management and reporting and helps your organization understand what it costs to run each of your programs. It also is the key to measuring the sustainability of each program.
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Benefits of Indirect Cost Allocations
Indirect Cost Allocations are critically important to all aspects of your organization. It affects the budget for all of your programs. It provides management with the information needed to make informed decisions. It will affect how your donor’s view the efficiency of your organization. And finally, it affects how much you are reimbursed for the services you provide.
The final result of your allocation method also determines the percentages of program, management and fundraising that will appear on your Form 990 and other reports. These final numbers are viewed by the general public and your donors to judge your organization’s worthiness for their contributions. If you are receiving grant money that allows for indirect cost allocations for recovery of reimbursable expenses, then the allocation you use will directly impact your bottom line and related management decisions.
All costs that benefit programs and cannot be identified to a specific program are first pooled and then allocated using a method that results in an equitable distribution.
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Examples of Indirect Cost Allocations
For example, Penny Lane Child Care rents a 5,000 square foot building that houses their administrative staff (1,000 square feet – 20%), child care programs (3,500 square feet – 70%) and fund-raising staff (500 square feet – 10%). All expenses related to the building costs, including rent, utilities, maintenance and insurance are pooled in a cost center that will be allocated to each functional and program area based on the square footage percentage occupied by the program. The allocation by square footage is an acceptable methodology for allocating indirect costs because it demonstrates an equitable distribution of those costs.
Payroll costs are another example of indirect allocations since each employee might work in different programs during the pay period. An equitable method of allocating gross salaries, payroll taxes and fringe benefits would be a percentage of the total actual time worked, or the total payroll dollars charged by all employees in each functional area.
For example, Tarheel Arts Center’s ten employees’ total time sheet for the pay period shows that they spent 45 percent of their aggregated time their High School Arts Program, 10 percent of their aggregated time on their Elementary School Arts Program, 30 percent on their Preschool Arts program, 10 percent on Administration and 5 percent on Fund raising. These percentages can be applied to the total pooled personnel expenses for the pay period.
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When developing an indirect cost allocations plan, examine the shared expenses you have and determine which methodology best fits the type of expenses to be allocated. Whatever methods you do choose should be used consistently, put in writing and be approved by your funding sources and your financial team. For additional resources on cost allocations, refer to OMB Circular A-122.
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Did you find this article useful? We welcome your thoughts and comments.
Christine Manor says
Hi, Joe! I’m enjoying the articles you post periodically. You deliver good information in digestible bits.
If I may, I have a couple of terminology points about the allocation article. It is a subject near and dear to my heart. When you talk about “indirect cost allocation,” most people are going to think about the OMB Uniform Guidance for government awards. This missive replaced all of the prior guidance documents (A-122, A-133, etc.). In that document, indirect cost allocation refers to allocating admin costs to programs to recover full costs of program.
Your article refers to cost pools which are often called “common cost” pools and there is often two of them – occupancy and payroll. For GAAP and 990 purposes, these common cost pools are emptied by allocating to the programs, admin, and fundraising. Admin costs are not allocated, except for purposes of government award reports.
As you say, an organization needs to determine the most appropriate basis on which to make the allocations. Basis is the accepted term, not methodology.
In some organizations you might even have “multiple basis, step-down allocations” in which the lowest cost pools are allocated first and the admin costs are allocated last. An example is an organization with multiple programs, each of which has it’s own basis for allocations – IT costs might be allocated based on percentage of space occupied on the website, salary costs might be allocated on actual or estimated time spent on each program, common program costs might be allocated by total dollars spent for each program in the group, occupancy costs might be allocated based on square footage or also by time spent on programs, and finally, admin costs would be allocated based on total program costs. Each step of the allocation process has its own basis and the order of the allocations is critical so that the lower levels don’t get allocations after they have been emptied.
I’m not really saying anything different than you said, just using slightly different words. As you can see, I love to talk about this stuff anytime.
All the best,
Joseph Scarano says
Thanks for the comments and the clarification. If we can ever help any of your nonprofit clients with our software, let us know.
Kylie Dotts says
I didn’t know that having a fair and equitable nonprofit cost allocation process was so important to financial management when running an organization. I think that running a business, whether nonprofit or for profit, would be a tricky task especially when considering all the finances that can be involved. It would probably be a good idea to find a good fiscal management service that could come and help you make sure that everything is running smoothly and organized in an effective way.
Joseph Scarano says
Yes, it is extremely important. Even though a nonprofit is a nonprofit, that does not mean they don’t need the financial data to measure the feasibility and sustainability of their organization. Without that information, they could not successfully fulfill their mission.
Thanks for your comments,