A Guide for Indirect Costing

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Indirect costs are usually difficult to isolate because they are joint with more than one activity benefitting the business venture. Indirect costs are mostly constant and are grouped as a fixed cost.  They are output costs like advertising, maintenance, security and computer services. Indirect costs are sometimes shared into programs for management purposes or fundraising. This means that activities like printing, postage, telephone and rent are also included in indirect costing.

Why Businesses Allocate Indirect Cost

Financial analysis is only effective when one applies full knowledge about the full cost of the program. The full cost includes a major portion of the overall costs of activities of the business. Knowing the full cost helps in knowing services that are free. This allows business people to request for reimbursement from supportive funders.

Methods for Allocating Indirect Cost

There are many methods used for allocating indirect cost. However, the most common methods are:

1. Case-by-Case Allocation: This method involves determining the actual usage rate of each program. That is to say that keeping track of certain activities helps in charging the appropriate program to pay monthly bills. This is why most companies maintain a time log or time track of the programs or functions. For example, keeping time track on employees helps in paying them on hourly basis. There are other methods businesses employ for time tracking and keeping a log of activities. The only setback with case-by-case approach is that it takes a lot of time for record keeping.

2. Establishing an Indirect Cost Rate: Here overall costs are first separated into two categories, direct and indirect. Total indirect costs are combined as a pool and then allocated into different sets based on proportion or rate.

An Example to Guide You

Consider a specific company with a budget of $3,300 which is distributes as follows:

Program A is 1/3rd of the total cost and therefore indirect costs must also be 1/3rd. Similarly, Program B is 2/3rd of the total cost, and indirect costs shall be 2/3rd of the total. The indirect cost rate will therefore be evaluated by dividing the total indirect cost by the total direct cost. Therefore,

Indirect cost rate for the company           =             Total Indirect Cost/ Total Direct Cost       x 100

=             $300/$3000         x 100      =             10%

The indirect cost associated with each program will therefore be calculated as:

Program A           =             $1000 x 10%        =             $100

Program B           =             $2000 x 10%        =             $200

Total Indirect Expenses                                   =             $300

After determining the rate of indirect costs associated with each program, the budget will be read as follows:

Budget = Direct Cost + Indirect Cost Rate

Program A = $1000 + $100 = $1,100

Program B = $ 2000 + $200= $2,200

Total Cost                                    $3,300

This is how indirect costing is allocated. Depending on what kind of organization it is, the guidelines vary. Some business organizations use the Federal Indirect Rate, and follow different guidelines. Similarly, non-profit organizations also have their own guidelines on allocating indirect cost.


Further reading: Corporate Governance | Audit | Performance Improvement

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