Indirect Cost Allocation

In addition to the direct cost of providing services, governments also incur indirect costs. Such indirect costs include shared administrative expenses where a department or agency incurs costs for support that it provides to other departments/agencies (e.g., legal, finance, human resources, facilities, maintenance, technology). The cost to governments to track every expense and directly attribute each cost to each function would exceed the benefits. Indirect cost allocation is an accounting function by which estimates are made to distribute indirect costs to programs or functions, in order to approximate their full cost. Certain important management objectives (measuring the cost of government services, establishing fees and charges, charging back the cost of internal services to departments/agencies, fully utilizing restricted funds, and requesting reimbursements under federal and state grants, when allowed) can be served by allocating indirect costs. Regardless of the purpose of an indirect cost allocation, a systematic and rational methodology should be used.

1. Who should perform the allocation? An indirect cost allocation can be performed either by the government’s own staff or by an external party. Specific factors that should be addressed in choosing between the two include:

• In certain political environments, a government’s constituents may be more accepting of an externally prepared cost allocation;
• The optimal choice may depend on the purpose of the cost allocation (for example, departmental chargebacks vs. grant reimbursement); and
• Regardless of who prepares the cost allocation, management needs to be involved in the process and knowledgeable about the methodology used.

2. What factors need to be addressed if an external party is selected to perform the allocation? If an external party is engaged to perform a cost allocation, the government should address the following:

• The need for independence may prevent the financial statement auditor from serving in this role;
• The selected preparer should have knowledge and experience that is specifically relevant to the purpose for which the cost allocation will be used;
• The government should obtain ownership of the final work product;
• The government’s staff should obtain at least a basic understanding of the process used to prepare the cost allocation;
• For cost allocations that will be used for claiming indirect costs for grants, the contract for services with the preparer should state whether the preparer will assist in negotiating with a grant provider, if necessary, and which party (the government or the preparer) would be responsible for any indirect costs that are ultimately disallowed; and
• The government is responsible for having a system in place that ensures that data are appropriately classified in the accounting system.

3. How often should a cost allocation be performed? An indirect cost allocation should be evaluated annually to ensure that factors that can have a significant effect on the allocation (e.g. changes to cost centers, involvement of new funds). The basis and methodology for the cost allocation should be reviewed regularly to ensure the allocation is fair, consistent, reasonable and rational, based on the following:

• Complexity of the calculation;
• Changes in grant requirements;
• Purpose for which the allocation is to be used[1];
• Implementation of a new enterprise resource planning (ERP) system;
• A significant change in economic factors affecting cost basis (e.g. inflation);
• A change in the government’s administration; or
• A structural change in the government.

4. What factors need to be addressed if a cost allocation is to be performed by the government’s own staff? If in indirect cost allocation is to be performed by the government’s own staff, a team approach normally is preferable. That team should consist of stakeholders from the government’s departments/agencies and should have a designated team leader to make decisions when there are differing positions on the team and it is not possible to reach consensus. In addition:

• The internal staff that works on the project should have knowledge and experience that is specifically relevant to the purpose for which the indirect cost allocation will be used. Likewise, it is important that internal staff be aware of all applicable laws and regulations if the cost allocation is to be used as the basis for requesting reimbursement under an intergovernmental grant;
• The government should develop an educational process to ensure that the staff involved remain knowledgeable;
• Agencies/departments of the government should be responsible for using classifications which, to the greatest extent possible, identify direct costs, to maximize the amount recovered from grant providers, when applicable (also applicable to externally prepared cost allocations); and
• Data and the related source documentation should be captured and simultaneously to avoid audit problems that could otherwise arise as a result of subsequent data changes.[2]

5. Should the government use an indirect cost allocation plan or an overhead percentage rate? There are pros and cons to using either an indirect cost allocation plan or an overhead percentage rate for recouping indirect costs, regardless of whether cost allocations are performed by an external party or by the government’s own staff. Since an indirect cost allocation plan involves a greater level of detail and more complex calculations, a government should determine whether increased cost recovery from grantors and ratepayers would justify the extra effort.

6. What are other items that governments should address when developing an indirect cost allocation?

• The methodology used in the allocation should be fair, rational, and consistently applied with few exceptions to that methodology.
• The basis for allocation of each indirect cost should reasonably approximate the proportional share of service received from the service provider.[3]