Indirect Cost AllocationOct 25, 2022
A hot topic in nonprofit accounting is indirect cost allocation.
Essentially, indirect cost allocation is spreading the total cost of certain expenses across multiple programs to give yourself (and donors) a better idea of the actual cost of running each program.
Where this style of accounting gets tricky is understanding which expenses are direct costs, indirect costs, or joint costs.
In this article, we (Morris Verdonk Accounting) will cover:
- Each of the different pools of money (direct costs, indirect costs, and joint costs)
- How you can identify indirect costs
- How to spread indirect costs
- How indirect costs give you a better idea of the total program expenses
Three Pools of Money
Direct Cost Allocation
Direct costs are expenses that were used solely for a single event or program. You’ll label these transactions for “XYZ event” or for a specific program and the costs will be allocated to that area.
Joint Cost Allocation
Joint cost allocations get a little more complicated but, thankfully, aren’t as common. On the fundraising side, joint costs are governed by GAAP. Joint costs not on the fundraising side are not governed by GAAP and can be allocated based on a couple of different models.
As mentioned, this doesn't happen often, but here is an example of where joint cost allocation could come into play:
Say you are running a financial employment program and you go to do some fundraising with that program so you canvas all of your old students/customers. You call them and say “we have another program coming out, we’d love for you to join us. We have spaces available free of charge for you to join, and we’d love for you to give a donation”
This would be considered a joint cost, so you’d have to analyze it and determine if/where to allocate those funds.
Indirect Cost Allocation
As we mentioned, indirect cost allocation is spreading the total cost of certain expenses across multiple programs to give yourself (and donors) a better idea of the actual cost of running each program.
Before you start spreading indirect costs, you’ll need to sift through all of your expenses and find any that would be considered as a direct or joint cost. This will help you narrow down the expenses that can be split and allocated to individual programs.
There are different ways to spread indirect costs, so your goal should be to come up with a simple, repetitive method. By repeating the same method, in the event of an audit, you won’t have to explain why you changed your allocation method, instead, everything will be consistent.
Implementing Indirect Cost Allocation
To demonstrate one method for allocating indirect costs, we will explain how to distribute them to each program. Keep in mind, this doesn’t necessarily mean the program is going to reimburse that amount.
Let’s get started.
First, select a time period and the total expenses for that period. For example, you could use your 22-23 budget.
Next, you’ll figure out what the percentage of each one of the expense categories is of the grand total.
Then go through the P&L and look for all indirect costs. This is where you’ll separate indirect costs from direct and joint costs. Several examples of indirect costs include:
- Professional service fees
- Marketing for the organization as a whole
- Dues and subscriptions
- Office equipment
- Administrative payroll
Training could also be considered an indirect cost if it was for a higher-up who by getting trained, affects the whole organization. However, training for one person that only affects one program would be considered a direct cost.
To make this process easier, we suggest doing it quarterly.
What Can We Learn Through Indirect Cost Allocation?
Before you factor indirect costs into a program, it can look like the program is really successful. However, once you spread the indirect costs, it can be eye-opening to see what the actual cost of running the program is.
Inversely, if you don’t spread the costs, it can look like you are spending a lot more on administrative costs than you actually are. This is helpful because instead of showing a donor that you spent $400,000 on admin costs (for example), once the indirect costs are spread out, it could show you really only spent $100,000. This number is more appealing to a donor.
It’s important to note that spreading indirect costs doesn’t affect the total overall net income, but it does make administrative costs look better and shows a more accurate estimate of the total cost of each program.
Call on an Expert for More Guidance
As we mentioned, indirect cost allocation can give you a more accurate depiction of how your expenses are being used. This, along with other nonprofit accounting strategies can change the way you and your donors view your finances.
If you have more questions about indirect cost allocation or managing your nonprofit’s financials in general, contact Morris Verdonk Accounting today! We’d love to learn more about your organization and strategize new ways to help it thrive financially!
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