Nonprofit Accounting Basics

Is There an Ideal Indirect Rate?

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Those of us who develop indirect rates wonder if there is an ideal percentage amount. It is akin to asking “what is the meaning of life”. I’ll attempt to answer the former question.

Before I digress, let’s cover some common ground. An indirect rate of 10% is comprised of a numerator (referred to as the “cost pool”) such as $100,000 divided by the denominator (called the “allocation base”) of $1,000,000. For nonprofit organizations receiving federal grant funds, OMB Circular A-122 prescribes the appropriate methodology for developing an indirect rate. Each federal agency has their own indirect rate model template so that federal grantees (nonprofits) can establish a yearly Negotiated Indirect Cost Rate Agreement (NICRA).

The lowest indirect rate percentage is the most ideal. A-122 permits different allocation bases (denominators) such as direct labor, direct labor and applied fringe benefits, or direct labor with fringe and other direct costs called the Modified Total Direct Cost (MTDC) base. If the cost pool remains unchanged, the larger the allocation base, the lower the resultant indirect cost rate. Why is it the best indirect rate scenario?

Here’s an example. A nonprofit has a total General and Administration (G&A) rate of 15%. The G&A rate is comprised of 5% for occupancy functions and 10% for administrative functions such as executives, finance, HR, IT, and purchasing. The nonprofit receives a Private Foundation Grant (PFG) that limits the overall G&A rate to 9%. Looks like the nonprofit will not recover 6%., i.e. 15% minus 9%. By the way, this nonprofit uses the MTDC base methodology to compute their G&A rate. Had they used Direct Labor as the allocation base for G&A, their G&A rate would be double at 30%.

Under A-122, the nonprofit is permitted to allocate and charge an allocable portion of their occupancy as a direct charge to their grants using the “Direct Allocation Method”. Since they can allocate the 5% occupancy as a direct charge to the PFG (if permitted by that granting organization), only the remaining 10% is applied to recover administrative costs. Now that the 5% occupancy piece is treated as a direct charge, the remaining 10% G&A rate is compared with the 9% PFG ceiling for cost recovery. Since the organization separated occupancy from administration, they will only loose 1% (10% minus 9%) recovery of their indirect cost instead of 6%.

The ideal percentage is the indirect rate with the largest denominator or allocation base. As we previously stated, they used the larger MTDC base that resulted in a 15% G&A rate. Had they used a smaller Direct Labor base, the G&A rate would have doubled to 30%.

If the nonprofit used the smaller Direct Labor base with a G&A rate of 30%, they would have been faced with a ceiling rate of 9% versus their 30% and not recover as much as 21%. This could be somewhat mitigated by the breakout of their occupancy cost but they still would have a larger margin of indirect cost that would not be recovered. This is why a larger allocation base resulting in a lower indirect rate is preferable.

There is another important reason to have a larger allocation base and lower G&A rate. That reason is perception from the public. Face it, most people, even those awarding federal grants or PFG do not always understand cost accounting or indirect rates. They think, the larger the indirect rate, the more their organization has to pay for a nonprofit’s administrative costs. That is why private foundations, universities, state and local governmental entities tend to put artificial constraints on how much an organization may recover with respect to indirect cost. It is not that they are questioning your indirect rate methodology rather for purposes of negotiation they are only willing to pay, for example, 9% of your indirect cost. On the other hand, federal agencies will pay the entire amount of your indirect cost rate (regardless of how much is your percentage) provided your methodology has been reviewed and approved, and of course there is sufficient funding to cover your indirect expenses.