Cost Allocation - Why it Matters
Correctly allocating costs among an organization’s programs can be one of the most challenging aspects of non-profit book keeping. It may seem simple enough: whatever you spend to pay a program’s staff and purchase the supplies that they use will equal the cost of the services they provide. Well, these may be the program’s direct costs, but they don’t represent its true cost. There are other expenses, too often overlooked and under funded, that contribute to every program’s bottom line.
Indirect costs (also referred to as “Administration and Support Costs”) are expenditures necessary to the overall management and operation of an organization. These include costs associated with general record keeping, business management, budgeting, board activities, legal expenses and other tasks that are not specific to any one program—including just keeping the lights on. Indirect costs also generally include the salaries and expenses of the organization’s chief officer and his or her staff.
Cost allocation is a way of accounting for each program’s share of these indirect costs. There are four generally accepted methods:
(1) Simplified Allocation Method
This method allocates indirect costs by use of a distribution percentage derived from a program’s direct costs, i.e. total employee compensation and other expenses. In other words, a more expensive program will account for a larger share of the indirect costs.
(2) Modified Direct Method
This method is similar to (1), but employs an additional allocation process for certain direct costs that are shared among two or more programs.
(3) Multiple Allocation Base Method
This method is used when a program, affiliate or subsidiary is different from an organization’s other activities and receives a disproportionate amount of administrative support. In these cases, the formula for figuring the allocation is not one-size-fits-all, but instead varies by program type.
(4) Approved Federal Indirect Cost Rate
Many non-profits that receive Federal assistance have approved Federal indirect cost rates. These rates are very useful in budgeting, particularly when developing a Federal grant proposal.
Whatever the size or complexity of your organization, you should choose your cost allocation method carefully. Indirect costs are an important piece of price setting that can make the difference between a successful organization and an unstable one. Understanding indirect costs can also help you increase efficiency and distribute your organization’s resources in a way that maximizes program outcomes.
