Did you know that poorly allocated indirect expenses could cost your nonprofit vital funding?

What are indirect expenses?

Indirect expenses, also known as overhead or operating costs, are expenses that support the organization’s general functioning but cannot be directly attributed to a specific program, project, or activity.

Common examples of indirect expenses for nonprofits:

• Administrative personnel costs
  • Salaries, payroll taxes, and benefits for staff members in roles such as executive leadership, accounting, human resources, and office administration
• Office rent and utilities
  • Leasing office space and paying for electricity, water, internet, and phone services
• Office supplies and equipment
  • General supplies like computers, furniture, and consumables that aren’t tied to a specific program
• Insurance
  • Liability, property, directors and officers, cyber security, and worker’s compensation policies for the organization
• Marketing
  • Platform or software subscriptions, public relations activities, website maintenance, and market research
• Depreciation
  • Gradual decrease in value of the organization’s long-term assets, like buildings and office equipment

Why do indirect expenses need to be allocated?

Now that we understand the importance of allocating indirect expenses, let’s explore the methods nonprofits can use.

• Budgeting and Planning: Allocating indirect costs helps set accurate budgets for future programs and operations, ensuring the nonprofit has the resources it needs for growth and sustainability.
• Program Costing: If indirect expenses aren’t properly allocated, the organization won’t know the true cost of delivering each of its programs. This can lead to inefficiencies and a distorted view of where resources are being consumed.
• Transparency and Accountability: Donors and grant-makers want to ensure that their contributions are being used effectively, with a reasonable portion going directly to the programs and services that fulfill the nonprofit’s mission. Properly allocating indirect expenses demonstrates that the organization is managing funds responsibly and staying within donor expectations.
• Grant Reporting and Compliance: Many grantors have policies around allowable indirect costs and require a breakdown of how funds were spent to ensure only allowable costs are being covered and reported. Failing to allocate indirect costs properly can result in loss of current and future funding.
• GAAP and Information Return Compliance: A statement of functional expenses needs to be prepared for 501c3 and 501c4 organizations that require a full IRS Form 990 and/or annual audit. Allocation of indirect expenses is necessary to prepare an accurate statement of functional expenses.

Now that we understand the importance of allocating indirect expenses, let’s explore the methods nonprofits can use.

Methods for allocating indirect expenses

There are various methods nonprofit organizations can use to allocate indirect expenses. The size, complexity, and operational structure of the organization dictate the best allocation method to use.

Simplified Allocation

This method uses a fixed percentage of total expenses to allocate indirect costs. This is a basic approach and is one of the least accurate allocation methods. It’s best used in smaller organizations with one primary function (program/project).

Direct Allocation

In this method, all costs other than general and administrative expenses are considered direct. Joint costs such as rent, utilities, insurance, deprecation, etc. are prorated individually as direct costs to each function (program/project) using the allocation base (square footage, employee FTEs, salaries) most appropriate to the particular cost. The allocation bases must be established in accordance with reasonable criteria and be supported by current data.

This method provides more accuracy than the simplified allocation since it accounts for different organizational functions and is best used in small to mid-sized organizations.

Multiple Allocation Base

In this method, indirect costs include general and administrative and joint costs. Indirect expenses are grouped based on their nature (expense account/category), and an allocation base is applied to each indirect cost group by function (project/program). The resulting allocations for each cost group are then combined to create an indirect cost rate for that function. The cost groups and allocation bases are outlined below (in the order that they should be allocated).

• Facilities
  • Depreciation: Costs of buildings, improvements, and equipment allocated based on usage (square footage, employee FTEs, salaries)
  • Interest: Allocated: like depreciation
  • Operation and Maintenance: Rent, utilities, repairs, security, and similar expenses, allocated like depreciation
• Administration
  • Costs of executive and administrative offices allocated based on Modified Total Costs (MTC), incorporating direct and indirect cost proportions.

This method is the most complicated, but it provides even greater accuracy and flexibility than the direct allocation method. The multiple allocation base method is best used in larger and/or complex organizations with great variance in function and/or cost-benefit relationships. In addition, this allocation method requires compliance with detailed federal guidelines, so the organization needs the resources to track and manage data at this level.

Special Indirect Rates

In certain cases, a single indirect cost rate may not be appropriate because different factors can significantly affect indirect costs for specific segments of work. A “segment” may refer to work under a single federal award or a group of awards performed in a common environment. Factors influencing indirect costs include physical location, administrative support requirements, nature of facilities or resources, scientific disciplines or technical skills, and/or organizational arrangements.

If a segment generates notably different indirect costs, a separate indirect cost pool and rate should be developed during the allocation process. This is valid if the resulting rate differs significantly from standard rates and the work volume to which the rate applies is substantial.

Negotiated Indirect Cost Rate Agreement (NICRA)

This is a formal agreement between an organization and its cognizant federal agency that establishes the percentage of indirect costs (e.g., administrative expenses, facilities costs) the organization can charge to its federal grants or contracts. It is determined based on an organization’s financial data and cost allocation plan and is reviewed and approved through negotiation.

This method is beneficial for organizations with large federal funding portfolios or growing federal funding portfolios and complex cost structures as well as organizations that are looking for a consistent rate that still allows for equitable cost recovery.

De Minimis Rate

This rate is a simplified method for organizations to recover indirect costs from federal grants. The rate changed from 10% to 15% of modified total direct costs (MTDC) as of October 1, 2024. The de minimis rate can be used indefinitely once elected as long as the organization consistently applies it across all federal awards, but it can’t be applied if an organization received a NICRA in the past. Utilizing this indirect cost rate is practical for smaller organizations with minimal indirect expenses.

Compliance Considerations

If an organization chooses a method other than a NICRA or the de minimis rate, it must comply with 2 CFR Part 200 (Uniform Guidance) by ensuring costs are

1. Reasonable: Necessary for the organization’s operations.
2. Allocable: Assigned proportionally based on benefits received.
3. Consistently applied: Treated the same way across all functions and funding sources.

The organization should also have documented support for the methodology chosen and how the indirect expenses were calculated.

Importance of Proper Allocation

Allocating indirect expenses effectively is important for nonprofits to maintain financial health, comply with regulations, and build trust with stakeholders. By choosing the right allocation method, organizations can ensure their resources are used efficiently to fulfill their mission. For help determining the right allocation method for your organization, reach out to Wegner CPAs Nonprofit Advisors.