The “burden” of indirect costs remains one of the top concerns for both nonprofit organizations and their donors. Faced with limitations on indirect cost recovery from private foundations, shrinking federal dollars, and the increasing costs of program oversight, organizations grapple with a number of serious and conflicting concerns in this area. How do organizations adapt to the changing regulatory and market environment in which they operate? While indirect costs are necessary expenses toward the management and viability of the organization, many donors view such costs as a “tax” to their sponsored programs, and most organizations struggle to overcome that preconception.
What are indirect costs and why is there so much discomfort and stigma around cost recovery?
One significant challenge in getting key stakeholders to understand the indirect cost paradigm is that there is no specific list of costs that are required to be indirect. This means that the organization itself defines which costs are designated as direct and indirect, based on its business structure, programs and other factors. While we generally see expenses such as executive wages, home office facilities and general accounting in the indirect cost category, there is no single method of defining which expenses should be included. Further complicating the discussion is multiple pools of costs, such as overhead and general and administrative (G&A) that organizations use to accumulate and allocate costs. The term “overhead” is generally used to describe the costs associated with maintaining the organization while G&A costs are typically those associated with operating and managing the programs. Collectively these make up indirect costs to the organization.
Direct expenses, on the other hand, are all those that can be connected to an ultimate cost objective, i.e., programs. Organizations can count direct and indirect costs differently even if they provide relatively similar services and are of relatively similar size. For example, some organizations treat the costs associated with procurement management as a direct expense while others include such costs as an indirect cost in their general and administrative rate, and some even have a separate “subcontractor and materials handling rate.”
This very simple, yet real, example can have significant consequences on the underlying indirect cost rate of the organization. In the first instance, where procurement is a direct charge to the program, the indirect cost rate goes down, but the total direct charges increase. In scenario two, the reverse is true, direct expenses go down and indirect expenses increase. Yet in the third scenario, when procurement is treated as a separate pool, the overall overhead rate goes down with the inclusion of a marginal subcontractor and material handling rate. These examples illustrate that the same exact cost, in absolute terms, can be treated at least three different ways, each with differing impact to the indirect cost rates of the organization.
There is no doubt that the complexity and diversity in methodologies contributes greatly to the stigma surrounding indirect costs. In budget preparation and presentations to donors inclusive of federal agencies, indirect costs are typically presented as a rate, i.e., percentage of cost. From a donor’s perspective, there is a great deal of scrutiny involved in analyzing the direct expenses of an award, and yet at the end of the budget, there is a percent of cost, sometimes substantial, that has very little to do with the intent of the award. Hence, many donors truly believe that indirect costs are a “tax” to programs.
In the U.S. federal context, many organizations have a cognizant oversight agency that reviews the organization’s indirect cost rate annually. However, the group that manages this rate is different from those that review and award grants and contracts. Organizations with complex federal and non-federal donor mixes are tied to their federal indirect cost rates for the entirety of the organization, thus making oversight by their private donors nearly impossible. Further, very few private foundations have a verification process of indirect cost rates. Worse yet, many donors put caps on indirect cost recovery, or negotiate a rate less than the true indirect recovery rate of the organization, thereby creating a starvation cycle for organizations. If the organization is federally funded, this could also result in a non-compliant application of their indirect cost methodology.
How do organizations overcome the stigma?
- Implement cost-cutting measures to reduce indirect costs serves the immediate purpose of lower indirect cost rates, often making organizations more competitive on programs.
- Reconsider your structure. Many sophisticated organizations have several segments with varying rates, or multiple consolidating entities enabling them to have multiple rates to comply with the varying programs’ needs and donor requirements.
- Consider adding in service center allocations that move costs from your indirect costs to your direct expenses. For example, if an organization adds an IT service center which is allocated based on headcount, the cost of IT is moved out of the indirect costs and is moved to the direct expenses of the programs. The impact reduces the overall indirect cost rate.
- Look for different methodologies with which to allocate your costs. Some organizations have varying methods for more equitable distribution of indirect expenses, which serves to help donors evaluate indirect costs. For example, instead of allocating indirect expenses based on program expenses, look for a more appropriate driver based on your programs, such as direct beneficiaries, etc.
- Add additional notes to your budgets and requests for funding. While several donors have ceilings on indirect expenses, many do not. Do not simply apply your rate, but rather explain its composition and application. Let donors know these are real expenses and explain why they are necessary to the organization.
Reprinted from the Nonprofit Standard blog.
For more information, contact Andrea Wilson, managing partner, Nonprofit & Education Advisory Services, at firstname.lastname@example.org.
Warren Averett is an independent member of the BDO Alliance USA. This article was borrowed with permission from BDO USA, LLP.