Master the Essentials of Indirect Cost Rates

Master the Essentials of Indirect Cost Rates

Indirect cost rates can be one of the most complex aspects of grant-based accounting. However, they also help cover expenses that are necessary to keep a nonprofit running successfully.

James Moore nonprofit CPAs Corinne LaRoche and Katherine Munday join forces to simplify indirect cost rates. They define these rates and explain their function and how to calculate them. Corinne and Katie also discuss pitfalls to avoid and practices to help keep your grant-based accounting accurate.

What are indirect costs?

The Code of Federal Regulations (CFR) defines indirect costs as “costs incurred for a common or joint purpose benefitting more than one cost objective, and not readily assignable to the cost objectives specifically benefitted, without effort disproportionate to the results achieved.”

In other words, indirect costs benefit multiple objectives and are not readily assignable to a single program. Examples include the salary and related expenses of staff, accounting, equipment, utilities, rent and security costs.

CFR also mandates that indirect cost pools “must be distributed to benefitted cost objectives on bases that will produce an equitable result in consideration of relative benefits derived.” This means you need to ensure none of your grant programs are bearing more indirect costs than the others. Instead, a uniform percentage should be applied across your grants to cover indirect costs.

Determining whether a cost is direct or indirect can vary by organization, grant and budget.

“Ask yourself the question ‘Can this expenditure be easily attributed to a particular grant program?’ said Corinne, a James Moore partner. If the answer is yes, it’s probably a direct cost. If the answer is no, it’s probably an indirect cost.”

Keep in mind that indirect costs are different than administrative costs. Some administrative costs can be directly charged to a particular grant. For instance, perhaps only one of your grants utilizes the postage meter in your office. If so, you can directly charge the cost of that postage meter to that particular grant. Generally speaking, however, the majority of administrative costs will be pooled and charged through your indirect rate across all grants.

What is an indirect cost rate?

An indirect cost rate is a percentage used to distribute indirect costs across all cost centers that benefit from the services covered by these costs. It is calculated by dividing your indirect cost pool by your direct cost base.

“You’re coming up with a percentage that you’re going to use to distribute your costs that are sitting in your indirect cost pool. So you’re going to take those costs and apply them to all your grant programs in a uniform way,” Corinne said.

There are four types of indirect cost rates: provisional, final, predetermined and fixed. The most common types of rates are provisional and final.

A provisional rate is a temporary rate that you use for billing and reimbursement of indirect costs throughout the fiscal year. At the end of the year, you will true up your account based on your actual costs. If your costs are lower than the funding you received with your provisional rate, you do not get to keep the extra money. The funding agency usually takes the lesser of either your provisional rate or your actual costs. The advantage of a provisional rate, however, is its ability to help make budgeting easier.

A final rate is an indirect cost rate applied to a past period that is based on the actual costs of the period. It is not adjustable.

A predetermined rate is applied to a specific period of time, usually your organization’s fiscal year. It is based on an estimate of your indirect costs during that time period and is not adjustable.

A fixed rate is similar to a provisional rate. Instead of truing up at the end of the year, however, you carry forward extra money to the next year (typically via a lower rate).

Many federal agencies require grant recipients to use an indirect cost rate.

What are the benefits of an indirect cost rate?

The primary benefit to indirect cost rates is that they make for easier reporting and budgeting.

If you have an indirect cost rate, you can bill that amount to your grantor each month without the fuss of complex calculations until the end of the year, when you true up your account.

Indirect cost rates also help cover the overhead costs that nonprofits incur during their daily operations.

One drawback to an indirect cost rate is less flexibility. If you have more administrative indirect costs than expected, for example, you may not be able to recover all of them. Negotiating rates with granting agencies can also be a long, difficult process. You also typically have to finalize your rate each year.

How do you set your indirect cost rate?

There are several ways to determine your indirect cost rate.

If you receive federal funding, you will negotiate an indirect cost rate with your cognizant agency. This is the agency that provides you with the largest amount of federal funding. Once that rate is set, all other federal agencies and pass-through entities are required to accept it. If you receive a larger portion of funding from a different agency in the future, you will need to renegotiate your rate with your new cognizant agency. Therefore, if you have a variety of funding streams from multiple federal agencies that fluctuate year to year, this process can be quite difficult.

What if you indirectly receive federal funding that is passed through another agency? In this case, you don’t have a cognizant agency — but you still can get an indirect cost rate. You can either negotiate a rate with your pass-through agency or use the de minimis indirect cost rate, which is 10%.

“If 10% is enough to cover your indirect costs, then that’s a quicker process,” Corinne said.

Note that administrative cap is distinct from indirect costs. An administrative cap is a common component of federal awards and is calculated based on the total award you receive. Your indirect rate is a percentage applied to a base of costs.

How do you calculate and apply your indirect cost rate?

Before beginning negotiations with a funding agency, make sure you’ve calculated a rate that will adequately cover your indirect costs.

First, determine your indirect pool by separating your indirect and direct costs. You will divide this number by one of three base numbers: salaries and wages, salary wages and fringe benefits, or Modified Total Direct Cost.

To decide which base to use, consider which will help you best allocate indirect costs across all grants equitably. If the majority of your grants go to salaries and wages, use salaries and wages as your base. But if you have grants that are allocated differently, using salaries and wages as your base will not be equitable.

“Think about what would be distributed evenly across your grants based on the proportional share,” said Katie, a James Moore manager.

Modified Total Direct Cost, or MTDC, is the most common base to use. It is more difficult to calculate but can be the most equitable base when you receive many different types of funding.

MTDC includes all direct salaries and wages, applicable fringe benefits, materials and supplies, services, travel and up to the first $25,000 of each subaward. It does not include equipment, capital expenditures, charges for patient care, rental costs, tuition remission, scholarships and fellowships, participant support costs or the portion of each subaward in excess of $25,000. Other items may only be excluded when necessary and with the approval of your cognizant agency.

Dividing your indirect cost by your base will yield your indirect rate. For example, if your indirect costs are $100,000, and your base is $400,000, your indirect cost rate will be 25%.

In general, the greater your indirect costs, the higher your indirect cost rate will be. However, a higher rate does not necessarily result in more money for indirect costs. Remember that how you calculate your indirect cost rate is also how you have to apply it. The base you choose dictates how you will apply your rate.

Consider doing a trial run based on previous grants and costs to see if a given rate would have yielded enough money to cover your actual indirect costs.

Understanding the New De Minimis Guidance

Another option is charging a de minimis rate, which is 10% of MTDC. This can be used indefinitely, and no documentation is required to justify the 10% indirect cost rate.

New guidance from the Office of Management and Budget allows all entities to use the 10% rate on received grants starting Nov. 12, 2020. Previous guidance restricted this to entities that had never negotiated an indirect cost rate.

A benefit of using the de minimis rate is that it requires very little administrative burden; no negotiation is involved. Note, however, that the rate is not 10% of your award, but 10% of MTDC. You will still need to calculate your MTDC in order to use the de minimis rate.

“If you really need some more funding, it may be worth your time to negotiate a rate. Because if you could even get it from 10% up to 14%, that can make a pretty big difference in funding for your nonprofit,” Corinne said.

Avoid these common pitfalls:

• Remember that your rate is not applied to your total award. Your rate is applied to your indirect cost base, not the award amount. Keep this in mind, especially if you’re using the de minimis rate. You don’t want to end the year with extra costs that aren’t covered.
• Be prepared when applying for your rate. Make sure you have adequate documentation in your proposal. Define and justify your cost allocation plan in writing. Make sure your proposal reconciles to audited financial statements. Before you start negotiations, be sure to complete federal documents, such as lobbying certificates, salary information, trends analysis and so forth.
• You still need a cost allocation plan for most types of rates. You will still need to continue running your cost allocation plan even after receiving an indirect cost rate.
• Double-check for consistency when determining costs as direct or indirect.
• If you’re using a provisional rate, make sure it will be enough. Generally, the grantor will not provide extra funding if you go over your provisional rate.

Follow these cost allocation best practices:

• Make sure you document everything. Have documents readily available. Also, document your thought processes as you decide indirect and direct costs.
• Consistency is key. Be consistent in how you record costs as direct or indirect and how you apply your rate.
• Fairly allocated costs that exceed funder limitations may not be shifted to other federal sources. If you run out of funding, you may not be able to move funds from other sources to cover the gap.
• Maintain good timekeeping records. Keep records clean, concise and updated.
• Give yourself plenty of time. The process of pulling together all the documentation and calculations on your end takes time. Also, be prepared for a long wait after submitting documentation to your cognizant agency.

Finally, reach out to your nonprofit CPA to make sense of indirect cost rates and how to use them.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.