What is a Budgeted Indirect-Cost Rate?
Budgeted indirect-cost rate is an estimated method to allocate expenses to units in a production batch or cost pool. In other words, it’s way for management to assign costs to units that are produced in pools on a budgetary basis. Let’s take a look at how this method is derived and used.
What Does Budgeted Indirect Cost Rate Mean?
The budgeted indirect cost rate formula is calculated by dividing the budgeted annual indirect costs by the budgeted annual quantity of the cost allocation base. This is a mouthful, but it’s pretty simple. Basically, it’s dividing the indirect costs of producing the pool by the number of units in the allocation base, so we can assign a cost to each unit.
Indirect costs include costs which are frequently referred to as overhead expenses (for example, rent and utilities) and general and administrative expenses (for example, officers’ salaries, accounting department costs and personnel department costs).
Why Knowing How to Calculate Indirect Costs Matters
Most finance and procurement teams have little trouble identifying costs associated with direct procurement. Direct costs are straightforward and relatively simple: they’re the raw materials, components, direct labor costs, direct salaries, finished goods and professional services connected to the production of your company’s own products.
But indirect procurement is a horse of another color. Depending on the context, even seasoned pros might mistakenly treat terms such as indirect costs, shared costs, overhead costs, and administrative costs as synonyms. But the truth is, each of those terms have a contextual meaning that companies and organizations need to understand if they’re going to practice effective indirect spend management as part of their total spend management program.
Let’s take a look at some of the most important cost allocation terms:
Direct Costs can be connected to the production of your company’s goods or services. For schools and nonprofits, direct costs are those which can be specifically connected to a single program, project, or source of funding (both federal and non-federal).
Shared Direct Costs, also called common direct costs, are those specifically connected to either production, subcontractors, projects, departments, etc. For schools and nonprofits, this term refers to those direct costs connected directly to specific sources of funding, projects, or programs.
Indirect Costs are those with no direct association to a finished product or particular program or project. These costs are shared across the organization because they’re necessary to completing daily operations. Office supplies, capital expenditures, IT services, and salaries and insurance are all examples of indirect costs. They can be allocated individually, or calculated using one or more cost allocation methods involving an indirect cost rate (also called simply an indirect rate) and assigned to a single line item in the budget as “indirect expenses.”
Administrative Costs, while often assumed to be indirect costs, are actually a mix of direct and indirect costs, based on whether a specific expense can be tied to production or a specific program or project. For example, fringe benefits such as a company car or discount card may be considered a direct cost provided they can be justifiably allocated to production.
Overhead Costs are familiar to most procurement and financial professionals. Unlike nonprofits or schools, where the term generally refers to fundraising and, to a lesser extent, “the business of doing business,” for businesses the term hews almost exclusively to the latter definition. Rental costs, utilities, insurance, taxes, depreciation, salaries and wages…overhead costs aren’t directly tied to production, but they do pay for the support structures surrounding production.
Indirect spend management takes these factors into account and focuses on complete, transparent, and accurate allocation of expenses.
Obviously, a small business or corporation will take a different approach to calculating indirect costs. They answer to lenders, investors, and shareholders rather than funders and grant administrators, but companies still need reliable ways to identify, quantify, and then optimize their indirect costs in order to achieve optimal financial health. Effective indirect cost allocation and management can also help companies and organizations center procurement as a value creation center rather than a budget trimmer through:
- Greater spend transparency.
- More accurate financial reporting, budgeting and forecasting.
- Improved cash flow and strategic spend.
- Eliminating waste and inefficiency.
How to Calculate Indirect Costs
Because their connection to production or a specific program or project isn’t always readily apparent, indirect costs can be more difficult to allocate correctly (and completely) than direct costs. And some expenses, like utilities, insurance, and wages simply can’t be neatly packaged up by percentages, with x% of a day’s wages supporting Project Y or z% of a day’s electricity powering the computers used for Production Line Q.
There’s no need to panic, however. The secret of effective indirect cost allocation lies in finding ways to treat indirect expenses as a single shared cost, and then finding ways to divide it up across projects, business units, production lines, etc. in a fair and proportionate way.
Some of the most common methods indirect cost calculation (IDC) include:
1. Fixed Cost Classification
The most basic of indirect cost allocation methods, fixed cost classification works best with (brace yourself) fixed expenses such as indirect labor costs, depreciation, and rent. These costs are recorded as charges to specific assets, projects, departments, subcontracts, business units, etc.
For example, wages for the marketing team are allocated to the marketing manager’s budget, office supplies are allocated to the department that ordered them (or, alternatively, to the business unit under whom multiple departments will share the supplies), and depreciation on a company copier is allocated to the copier itself.
2. Proportionate Allocation
“To each their own” is the principle underpinning proportionate allocation. Using this method, indirect costs are shared out among projects, departments, business units, etc. based on the type of cost and how the goods or services so purchased will be used. These percentages can be assigned monthly but are generally calculated, allocated, and reviewed once every fiscal year.
So, the company’s Internet services might be split evenly among the budgets of every department, whereas cleaning services might be allocated based on the square footage of a given department.
3. Activity-Based Cost Allocation
This approach to allocating your total indirect costs takes more time and effort, but is also much more accurate than proportionate or fixed cost allocation. To collect the data needed for indirect cost calculation, managers:
- Identify and record all business activities within their department for a given accounting period.
- Categorize these activities as direct or indirect costs.
- Analyze all costs and calculate indirect cost rates at the end of the accounting period (e.g. a month or a quarter), then allocate indirect costs accordingly.