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Indirect Rates

Indirect and Direct Costs

What does a project really cost?

Most of us have a pretty good idea what labor and materials are required for a particular project. We know how many hours that specific tasks take, and whether those tasks can be handled by an administrative assistant or need the technical skills of highly educated engineer, scientist, or data encryption expert. We know how many O-rings, test tubes, and widgets that specific tasks take, and how much they typically cost.

In addition to direct costs, each project (or division or product line) absorbs a portion of the cost of running the business. The rent or mortgage payments, electric bills, and receptionist’s wages are all necessary to run the business. Without them, the project could not be accomplished; therefore, a portion of their costs are allocated to the project.

The real cost of any project encompasses both the direct costs for that particular project plus a portion of the cost of running the business. The indirect costs represent cash money out-the-door that must be accounted for among the goods and services sold. No customer is paying for the Indirect Cost Project. Instead, those costs are allocated among projects, increasing the total cost of sales.

Which Term Applies

What’s the difference between Overhead and G&A? Why do some companies have more than one Overhead? Which costs are indirect, as opposed to direct?

Let’s explore the last question, first. Any cost that cannot be reasonably attributed to a particular project (or division or product line) is an indirect cost. Note that we do not have to allocate all indirect costs on the same basis or by the same method. The ultimate question is, “If not for this project, would the company incur this cost?” If the answer is no, then the cost is direct. If the answer is yes, then the cost is indirect.

Sometimes, the answer has a caveat. If not for this project, the company would still incur this cost – but only for the benefit of other projects that have a shared characteristic – not for the benefit of the company as a whole. For example, the company has three projects training customer participants. These three projects are in addition to providing other goods and services, which have nothing to do with training. The cost of the easels, projectors, and design of training templates are indirect costs; however, they are allocated to only the training projects – not to all projects. Indirect costs are allocated on a causal/beneficial basis. The cost of developing slides for one of the training projects is a direct cost to that project, because the cost would not be incurred at all, if not for that project. The cost of designing templates, used on all training projects, is an indirect cost.

General & Administrative, or G&A, costs are those relating to the company as a whole. These encompass facilities, administration, and general costs. Facilities costs include:

  • Rent or mortgage
  • Electric and gas
  • Cleaning and plant watering
  • Routine building maintenance

Administration costs include:

  • Company-wide accounting and budgeting
  • Administering employee benefits, employee reviews, and related human resource activity
  • Reception
  • Meetings of the owners or board of directors.

Examples of general costs include:

  • Company party to celebrate holidays
  • All-hands staff meetings
  • Employee training on Communication Skills.

For small businesses, indirect costs that do not logically fit into Overhead are usually included in G&A for simplicity. The total pool of G&A costs is allocated on one basis; it is one overall pool caused by or benefiting the entire company.

Those costs that cannot be reasonably attributed to a particular project, but relate to Direct Labor, are Labor Overhead (usually called Overhead). In small businesses, the project manager generally charges the project/job directly for time worked on the project. What about indirect costs related to services/labor of the project manager? Examples might be:

  • Salary for time taking training related to the type of project (as opposed to, say, communication skills or time management)
  • Computer software used to schedule work, by labor category, on multiple projects
  • Computer accessories used only to support Direct Labor on projects (not administration)
  • Labor on projects that would have been charged direct, except that each task (such as floor-sweeping in a production shop) is too small to track separately on timesheets and is “pooled in a bucket” for allocation among all benefitted projects
  • Paid Time Off for labor charged directly to projects and to the Overhead Pool

Note that, a case can be made for including any of these costs in G&A or another pool. The last on the list can be charged to an intermediate Fringe Pool and allocated to other indirect pools. Costs are recorded the same way, consistently, in like circumstances; if Project Management labor is recorded as Direct Labor on one project, then Project Management labor is recorded as Direct Labor on all projects. If recorded as part of the Overhead Pool, it is always recorded as part of the Overhead Pool. The defining question: Is the inclusion supportable?

If time is tracked manually or if employee benefits and employment taxes are not significant (perhaps less than ten percent of salaries and wages), calculating Overhead costs versus G&A costs might be too cumbersome. A logical method of labeling accounts by type of indirect cost can result in one all-inclusive indirect cost pool, four different Overhead pools plus a separate G&A pool, or any other supportable structure. Depending on the nature and size of projects, multiple Overhead pools might include:

  • Engineering Overhead, for indirect costs related to engineering labor, such as Computer Aided Design time
  • Material Overhead, for indirect costs related to material, such as placing Bill of Material purchase orders
  • Information Systems Overhead, for indirect costs related to computer systems, such Internet Service Provider fees
  • Training Overhead, for indirect costs related to providing training to customer participants, such as easels and projectors

Each pool of Overhead costs is allocated on a causal/beneficial basis. For example, Material Overhead is usually allocated on direct material dollars. Instead of some project incurring a cost of twenty dollars for test tubes, the allocated cost for placing the purchase order for test tubes is added, making the project cost twenty-one dollars.

Although one or more pools of indirect costs are allocated among projects, the labels for indirect pools fit the unique structure of each individual company. The number and label of pools is logical and supportable. The method used makes sense in the circumstances, to allocate indirect costs on a causal/beneficial basis.

We’ve explored what an indirect cost is, and is not, plus several kinds of indirect cost pools. Let’s analyze how we can best get the rent payment allocated to a specific project.

What Basis Should Be Used for Allocation?

The method for allocating a pool of indirect costs is determined by what caused the costs and/or what benefits from the costs. The easiest example is one, all-inclusive indirect cost pool allocated on all direct costs. For example:

All indirect costs total $300,000. All direct costs total $500,000. The Indirect Cost Rate (ICR) is 60% ($300,000 divided by $500,000). For every one dollar of direct costs charged to a project, an additional sixty cents are charged for indirect costs. The direct cost of all projects is $500,000. By adding 60% of the direct costs to each project, the total costs charged to all projects is $800,000 ($500,000 times 60% equals $300,000. $500,000 plus $300,000 equals $800,000.) One project’s costs might be:

Direct Labor $25,000
Direct Material 15,000
Other Direct Costs 10,000
Subtotal $50,000
Indirect Costs 30,000
Total Project $80,000

One, all-inclusive indirect pool of costs can be allocated on a basis other than total direct costs. A different base might be supportable, such as a service provider that uses billable labor hours of its homogeneous workforce. In that example, $300,000 of indirect costs could be allocated to a company-wide total of 500,000 billable hours at an “add-on” rate of six dollars per hour ($300,000 divided by 500,000 hours).

Note that, if more indirect costs are incurred to support the senior worker than the junior worker, then billable dollars – instead of billable hours – would be a more appropriate base.

Multiple indirect pools can each be allocated on a different basis. Again, the key is the causal or beneficial relationship between the indirect pool of costs and the base on which that pool is allocated. Material Overhead might be allocated on Direct Material dollars. Training Overhead (incurred for presentations of training) might be allocated on the number of hours of training presented; in this case, a two-hour training presentation would carry one-fourth the costs of an eight-hour training presentation. If the direct costs of the two-hour training presentation exceed those of the eight-hour presentation, allocation (of presentation tools) should not be based on direct costs

Any supportable base for allocation is acceptable. Examples of allocation bases include, but are not limited to:

  • Total direct costs
  • Total direct labor dollars
  • Total direct labor hours
  • Total direct material dollars
  • A portion of any of the above, based on records (usually the general ledger account) that segregate that portion, such as direct project management hours (if they are documented separately from other hours worked by project managers) or direct travel costs
  • Total number of employees
  • Total square footage
  • Total machine hours
  • Total number of one-way trips

Note that indirect costs from one pool can be allocated to another indirect cost pool. This is an intermediate pool. For example, Information Systems costs can be allocated based on the number of employees. The employees in the Accounting Department and the Human Resources Department use Information Systems. Some costs for Information Systems are allocated to the G&A pool (based on the number of employees in G&A departments). After that allocation, the G&A pool (including its share of Information Systems costs) is allocated among jobs with direct Cost of Goods Sold.

A common example of an intermediate pool is Fringe. All costs for employer-paid benefits and employer-paid payroll taxes can be accumulated in a Fringe Pool and allocated to an Overhead Pool (for Direct Labor and Overhead Labor) and to the G&A Pool (for G&A Labor).

Most small businesses do not need multiple tiers of indirect pools, or cost centers. Multiple levels of allocations are only warranted when one ICR, or one Overhead and one G&A rate, result in a significant misallocation. A complex indirect structure is only used when a simple structure skews the causal/beneficial relationship.

Is the Rate Too High?

Even when comparing companies in the same market, an indirect rate comparison cannot be made. One company might include the cost of scheduling and reserving project travel itineraries as a direct cost to the project, while another company includes developing all travel itineraries in the ICR. One company might allocate the cost of employee benefits based on the number of employees (and the project to which the employees are assigned), while another company includes employee benefits in G&A. Are employee benefits a direct cost of the project, a cost of the company (as a whole) doing business, or a cost that follows related labor hours or labor dollars?

The accounts included and excluded from the pool, the method of allocating indirect costs to a base, and the supporting logic for this method are vital to any analysis. We can evaluate the costs of a specific general ledger account, which happens to be in an indirect pool; the costs for that one account might be too high. The rate, itself, reveals very little. Instead of analyzing the rate, analyze the costs in the pool and in the base.

If indirect costs go down, the indirect rate also goes down. Minimizing purchases in indirect pool general ledger accounts, results in lower rates. Also, while labeling an account as an indirect cost is often easier, consider which accounts can be re-labeled as direct costs – and how those costs can be captured (and documented) as benefiting specific projects. For example, if the employee performing Project Management can easily distinguish that work on Project A from that work on Project B, the timesheet can reflect each and be charged as Direct Labor (not charged to a comingled indirect pool). By re-labeling an account as direct, both the pool costs go down and the base costs (generally) go up. The rate plummets from each.

“Too high” is a relative description. Analysis of Overhead, G&A, and other Indirect Cost Rates requires detailed review of the pool costs and the base costs. The more complex the structure of the allocation methods, the more analysis is required. One size does not fit all