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The Benefits of Obtaining a Federally Approved Indirect Cost Rate

April 1, 2019

by: Raymond Blake, CPA

Many social service type nonprofits receive some government funding, including federal funding, to operate programs that fulfill their mission. Those nonprofits that receive federal funding often derive it from a local government, such as a city, county or state and not directly from a federal agency. Nonprofits can also get federal government funding for almost every type of social service, such as child care (Headstart and 21st Century); job training programs (Workforce Investment Act); housing programs for the elderly or disabled (Supportive Housing for Persons with Disabilities); and senior citizen programs to run senior centers (Special Programs for the Aging).

The funding for these types of programs typically covers direct program expenditures but not enough (or any) of the indirect overhead costs that the nonprofit incurs in its operations. As a result, nonprofits are often not receiving sufficient funding to fully cover their costs.

Indirect costs are necessary for all nonprofits to operate their programs. Indirect costs include the managerial staff, such as the Executive Director, Chief Financial Officer and their staff; Human Resources and IT staff; and depreciation costs for property and equipment. Without adequate funding, a nonprofit would have to rely on raising additional revenue through contributions and/or special events to cover those allocable costs.

Indirect costs are defined as those that have been incurred for common or joint objectives and cannot be readily identified with a particular final cost objective. These costs are usually applied on an equitable basis across all of the nonprofit’s business activities according to the benefits each will derive from them.  An indirect cost rate (ICR) is the ratio between the total indirect expenses and a direct cost base. A nonprofit establishes an ICR through negotiations with its cognizant federal agency by submitting an ICR Proposal and other supporting documentation, which is subject to review and/or audit.

Types of Indirect Cost Rates

It is important to understand which ICR is appropriate for your nonprofit when considering an ICR proposal:

  • Predetermined rate is an ICR that is applicable to a specified current or future period, usually the organization’s fiscal year. The rate is based on an estimate of the costs to be incurred during the period. A predetermined rate is not subject to adjustment.
  • Fixed rate is an ICR that has the same characteristics as the predetermined rate, except that the difference between the estimated costs and the actual costs of the period covered by the rate is carried forward as an adjustment to the rate computation of a subsequent period. This rate may be negotiated where predetermined rates are not considered appropriate.
  • Final rate is an ICR applicable to a specified past period and is based on the actual costs of the period. A final rate is not subject to adjustment.
  • Provisional rate or billing rate is a temporary ICR applicable to a specified period which is used for funding, interim reimbursement, and reporting indirect costs on federal awards pending the establishment of a final rate for the period.
  • 10% de minimis rate may be elected by an organization that has never received a negotiated ICR. As described in 2 CFR section 200.403, costs must be consistently charged as either indirect or direct but may not be double charged or inconsistently charged as both.

Calculating Indirect Cost Rates

Allocating the indirect costs that your organization incurred can be done through one of the following  methods:

Simplified Allocation Method

The simplified method is the most common method for organizations establishing an ICR for the first time. It is used when an organization’s major functions benefit from its indirect costs to approximately the same degree. The allocation of indirect costs may be accomplished by: (1) separating the organization’s total costs for the base period as either direct or indirect, and (2) dividing the total allowable indirect costs (net of applicable credits) by an equitable distribution base. The result of this process is an ICR which is used to distribute indirect costs to individual awards.

Under this method, the rate is expressed as: the percentage of total allowable indirect costs to the base selected. The distribution base may be total direct costs (excluding capital expenditures and other distorting items like major subawards and participant support costs), direct salaries and wages, or other base costs to arrive at an equitable distribution. 

An organization should use this method if:

  • It has only one major function encompassing a number of individual projects or activities, or
  • The level of federal awards it receives is fairly small.

Multiple Allocation Base Method

When an organization has several major functions that benefit from its indirect costs in varying degrees, allocation of indirect costs may require the accumulation of such costs into separate cost groupings, which then are allocated individually to benefiting functions by means of a base that best measures the relative degree of benefit. The indirect costs allocated to each function are then distributed to individual awards and other activities included in that function by means of an ICR(s).

The determination of what constitutes an organization’s major functions will depend on its purpose in being; the types of services it renders to the public; its clients and its members; and the amount of effort it devotes to such activities as fundraising, public information and membership activities.

Determining Allocation Base

The following allocation bases are acceptable examples for use when indirect costs are allocated to benefiting cost objectives by means of an ICR:

  • Direct salaries and wages including (or excluding) all fringe benefits
  • Direct salaries and wages including vacation, holiday, sick pay, and other paid absences but excluding all other fringe benefits
  • Total Direct Costs
  • Modified total direct costs (MTDC) as defined in 2 CFR Section 200.68

 The selection of an appropriate allocation method should be based upon the commonality of costs to all cost objectives. 

ICR Proposal Submission

A completed ICR proposal submission involves the nonprofit organization’s ICR calculation and supporting documentation. The following checklist outlines the required documents that are required for submission:

  1. Organizational profile/mission
  2. Financial reports for the year under review
  3. Allocation methodology
  4. Listing of all grants and contracts
  5. Statement on unallowable costs
  6. ICR preparation policies and procedures
  7. ICR proposal
    • Detailing indirect expenses by function and cost category
    • Detailing fund distribution of the direct cost base by function 
    • Including a reconciliation between the proposal and the financial statements
  8. Allocation of Salaries and Wages
  9. Statement of Employee Benefits
  10. Completed Lobbying Certificate
  11. Completed Certificate of Indirect Costs
  12. Signed Cost Policy Statement (CPS)

A nonprofit that applies and receives a federally approved ICR will receive the additional funding to cover their overhead indirect costs and will not need to rely on contributions and special events just to break even. The federally negotiated ICR will be at least 10% and can be as much as 20% or more. A pass-through entity, such as a local government, is required to include a subrecipient’s negotiated ICR in the subaward, unless certain exceptions apply.

Marks Paneth LLP prepares Federal ICR Proposals on behalf of many of our non-attest clients. Our audit clients can also take advantage of this separate non-attest service if their indirect costs recovered by the auditee during the prior year did not exceed $1 million. For more information, contact a member of our Nonprofit Group.