Indirect Cost Allocation

Printer-friendly version
Type: 
Best Practice
Background: 

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). Certain important management objectives can be served by allocating these indirect costs (measuring the cost of government services, establishing fees and charges, charging back the cost of internal services to departments/agencies, and requesting reimbursements under federal and state grants, when allowed). Regardless of the purpose of an indirect cost allocation, a systematic and rational methodology should be used to calculate the amounts allocated.

Recommendation: 

The Government Finance Officers Association (GFOA) encourages governments to allocate their indirect costs. There are a number of issues a government needs to address in connection with indirect cost allocation. Because of the varied reasons for which indirect cost allocations are performed, a one-size-fits-all approach typically is not possible. Therefore, the GFOA recommends that governments considering the allocation of indirect costs consider the following:

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 considered 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);
    • 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 considered if an external party is selected to perform the allocation? If an external party is engaged to perform a cost allocation, the government should consider 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;
      • 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 an externally performed cost allocation take place? An indirect cost allocation should be used for a maximum of three years (unless a law or regulation requires a shorter period). Moreover, an even shorter interval may be necessary based on the following considerations:

        • Complexity of the calculation;
        • Changes in grant requirements;
        • Purpose for which the allocation is to be used1;
        • Implementation of a new enterprise resource planning (ERP) system;
        • A change in the government’s administration; or
        • A structural change in the government.

        4. What factors need to be considered 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 a 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 that identify direct costs to the greatest extent possible to maximize the amount recovered from grant providers, when applicable (as should also be true for externally prepared cost allocations); and
          • Data should be captured and documented contemporaneously to avoid audit problems that could otherwise arise as a result of subsequent data changes.

          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 consider whether increased cost recovery from grantors would justify the extra effort.

          Committee: 
          Accounting, Auditing, and Financial Reporting
          Notes: 

          1 For example, a cost allocation used to chargeback costs to governmental departments/agencies may need to take place more frequently.

           

          This best practice was previously titled Taking Advantage of Indirect Cost Allocations.

          Approved by GFOA's Executive Board: 
          February 2014