Chapter 14
Indirect Costs and Other Despised Items
A famous professional athlete's commercial advertised a fund-raiser for his charitable organization with the assurance that “all money raised will go to direct services, and none to administration.” This well-meaning pledge neatly summarizes the prevailing attitude toward administrative—or indirect—costs. First, it says pretty plainly that administrative costs are unseemly and should be avoided. This is the dominant attitude toward nonprofits' indirect costs among the general public, most board members, and many nonprofit managers themselves.
This is a laudable sentiment. Who wants to pay for costs not closely associated with direct service delivery? It's hard to see how managers' lavish offices, company-paid cars, and multiple perks could help deliver better museum exhibits, more health care for kids, or superior graduate school courses.
The problem with the sentiment is not its general direction but that it is hopelessly naive. Administrative costs are an inescapable part of providing services, and no amount of well-meaning huffing will change that fact. Pretending that administrative costs can be wished away is either self-delusional or hopelessly out of touch with reality.
The second problem is that the athlete's pledge was selfish. Even if it were somehow true that his fund-raising follow-up really could ensure that not a single dime of the proceeds went to administrative costs—a dubious proposition—all he was really doing was playing a cost-shifting shell game. Someone somewhere along the line was going to have to pay for that overhead, and if he managed to avoid paying for his share it only meant that everyone else giving money to the organization was going to have to pay more than their fair share in administrative costs.
In an athlete's charity or in any nonprofit operation, there are costs that are not the direct and exclusive responsibility of any one program or service division. The CEO's salary, for instance, pays for a level of effort that cannot be attributed to a specific program because it was expended on behalf of the nonprofit as a whole. Payroll processing costs from an outside payroll service are another good example of an expense not attributable to direct service.
Theoretically, a huge accounting system and large amounts of staff time and patience could make indirect costs disappear. Everything would be charged directly to program services. Every 10 minutes the CEO spent in a meeting, every pencil the bookkeeper picked up to scribble an accounting note, every kilowatt that flowed into the organization's headquarters would be tracked and properly allocated to a specific service.
But does this really matter? Not only do we not need that level of detail to manage operations, the compromises and estimates that the whole scheme would entail would make any output misleading and possibly dangerously unreliable.
Now go in the other direction. Striving for the maximum degree of simplicity and convenience, one might forget about dividing up (allocating) most expenses and instead throw them into a big pool called indirect costs. Then, to get each different service to carry its own weight, figure out what portion of that pool should be assigned to each individual service or program. This would be a whole lot simpler than painstakingly coding each bill according to which service should pay it.
These are extremes. But they indicate the two poles between which nonprofit budgeting for indirect costs must play. Being reasonable types, we might be inclined to split the difference and attempt to find the elusive happy medium. Mathematically and accounting-wise this strategy may be perfectly acceptable, but it fails because it ignores human nature.
No one likes administrative costs, especially people who give money to nonprofit organizations that are expected to do good things with that money. To the average donor, money for administration buys paperwork and photocopies of paperwork, not active problem solving and services in support of the mission. Oversimplifying only slightly, a low indirect cost rate signals responsible administration to the average observer, while a high rate suggests waste.
Still, what are administrative costs? In the absence of funding sources' mandatory definitions, administrative costs are largely what you make them. This means that they are determined by a combination of accounting judgments and the capacity of administrative systems. This is the way it should be, with the burden on managers to make it right and make it accurate.
It should be thunderously obvious that a certain level of administrative cost is inevitable. One needs a central office and a financial operation of some size, and there are many other expenses that cannot easily be charged directly to programs but that are necessary regardless of how much direct service is provided. As a result, small nonprofits usually have the highest percentage of administrative expenses. Conversely, as a nonprofit grows, it can often add many more programs with only a modest increase in administrative cost. The secret is knowing that this dynamic exists, and how to manage it.
In our experience, most nonprofit executives are sincerely cost conscious when it comes to administrative expenses. They try to control administrative expense, and if they can't, it's probably because they can't control other expenses either. In the end, the governing force in reporting nonprofit administrative expenses is the environment in which the organization operates. If the environment signals through formal or informal means that it wants administrative expense reporting handled in a certain way, over time that is exactly what will happen.
Rules Govern Audits, Economics Rules Budgets
One of the infrequently acknowledged confusions that some nonprofit managers and even some board members struggle with is the difference between the rules of auditing and those of budgeting. The result is that the budgeting process can be seen as a miniature audit that becomes unnecessarily complex, while the auditing process is often shrouded in misconceptions. Most of this confusion comes from the tacit assumption that, because budgeting deals with numbers, it must operate in a similar way to auditing, which is often regarded as derived from a kind of higher mathematical authority.
The Similarities
To get at the differences, we'll start with the similarities. The biggest similarity is that both are accountability devices. Audits provide information that helps board members and executives to be accountable to funders, government officials, and the public at large. The public nature of the nonprofit tax return (the IRS Form 990) and the various national websites that keep years of these reports on file are the ultimate in low-cost, high-visibility accountability.
Budgets, by contrast, are internal accountability mechanisms. Where the Form 990 holds the entire organization accountable, budgets are the primary way to hold divisions, departments, and programs accountable. But even here there is a crucial difference. Budgets allow insiders to hold one another accountable, while audits allow outsiders to hold the entire organization accountable.
Budgets and audits also share definitions of the money they raise and what they spend it on, better known as a chart of accounts. While this may seem trivial, it's not. Consistency in the way one categorizes revenues and expenses makes it easier for insiders and outsiders to communicate about, track, and measure actual and planned activities. This is one of the reasons an audit includes a high-level summary of revenues and expenses whose raw data should be able to be tied back to budget documents.
A less compelling similarity is that both budgets and audits tell a story—at least to readers knowledgeable enough to infer it. But each approach tells the story differently: audits present facts, budgets represent hope.
The Differences
If the list of similarities is short, the list of differences is long. We'll cover some of the more important ones.
The major difference between these two standard financial tools is a simple one: audits look only at the past, budgets only at the future. Audits accomplish their objectives by asking two fundamental questions: (1) Did the financial event really happen? (2) Was it recorded properly? These two questions get at the core of an audit's value: outside assurance that insiders aren't defrauding the company and that they're following accounting rules.
Budgets, on the other hand, are as likely to raise questions as answer them (“Will we get that grant we're counting on?”). Budgets exist in real time, representing the hopes and expectations of their creators. This happens more formally when the budget document turns into a reporting tool (actual, monthly difference, etc.). Interestingly, the budget that becomes a monthly reporting tool also usually has a high-level structure similar to an audit's statement of activities, which is the yearly compilation of 12 months of internal financial reporting.
A little-understood aspect of audits is that, although they contain a year's worth of information, they really only represent one small point in time—the last day of each fiscal year. Although this sounds like a technicality, it can have significant consequences for nonanalytical readers.
For example, organizations can choose their own fiscal year. This option can permit shrewd organizations to report at their best time of the year. One Wall Street–traded for-profit company that provides higher education services throughout the United States has set its fiscal year to end in August. Why August? Because that is the month during which they have received the majority of their first semester tuition payments—without making any associated expenditures, such as faculty salaries and educational materials. As a result, August is the month when their revenues and cash balances are high, while their costs are low.
Budgets are intended to cover a wide range of time, usually a fiscal year, and no one day matters more than most. In a sense, this makes them more representative of the full set of conditions likely to be encountered during the year. The internal advantage is that wise planners won't be fooled by temporary good fortune. Budgets are also dynamic in ways that audits are not, because budgets are not susceptible to widely accepted rules. Because they are forward-looking, budgets can flag expected ups and downs.
The standard budget document is less a fiscal tool than an economic one. The normal budget-in-a-spreadsheet attempts to give predictability and timing to important economic elements such as staff time (FTEs) and revenue receipt. Other types of budgets, such as the cash flow projections, which we will deal with later, explicitly try to predict the ebb and flow of the organization-wide quantity of money.
By contrast, an audit validates—and potentially recategorizes—quantities of money that existed in the past. By definition, audits are not about the future but rather about decisions that have already been made. This is why audits can include what are called recategorizations and subsequent events, which are ways of making retroactive adjustments based on information that was not available at the time of the initial statement.
Different Kinds of Budgets
Board members and nonprofit executives are usually accustomed to yearly budgets with month-to-month reporting on revenues and expenditures. But there are at least two other forms of budgets that nonprofits should be aware of and that function in a similar planning capacity.
The first is a cash flow budget. Designed to track cash inflows and outflows on a monthly basis, cash flow budgets are especially useful for nonprofits without a lot of cash—or with a lot of it. Unlike an audit, a cash flow budget has no required format, but once again the common chart of revenue and expense accounts with monthly columns is usually the backbone.
Cash flow budgets are a good way to anticipate when cash inflow may slow down, or when there is a major change in cash spending for some reason (some groups such as school year programs need to plan their cash budgets carefully).
The second different form of budgeting is the capital budget. Again, there are no rules except economic ones. A capital budget will include the acquisition cost of an asset, such as a building or a piece of large equipment, its useful life (meaning how long it is expected to stay in use), its yearly depreciation, and the leftover value, if any, after its useful life ends. The sum of all capital assets' current values should align with a part of that year's balance sheet. This is a good example of the interrelationship between certain budgets and the accounting/auditing function.
Accounting and auditing is about your records; budgeting is about your future. Both are important, interconnected, and essential. (See Exhibit 14.1.)
Exhibit 14.1 Major Differences Between Accounting and Budgeting
| Accounting | Budgeting |
| Responsible to external parties (auditors) | Strictly internal |
| The records are closed at some point | Can always be revised |
| Must follow certain principles and standards | Good budgets follow conventional standards |
| Accuracy is attested | No attest required |
| Rules made by national groups | Rules are self-imposed |
| Laws may be involved | No legal requirements |
| Responsibility to outside parties | No outside oversight |
| Record historical conditions | Predict future decisions |
Still, It's Low That Counts
Having said all this, we must acknowledge the inescapable reality that a low overhead rate in a nonprofit carries huge symbolic value. The universal litmus test for casual observers is simple: Low overhead means a responsible organization; high overhead means a spendthrift group not worthy of any more money. So nonprofit managers have no choice but to keep their overhead rates as low as possible. To do that, they must master the intricacies of overhead calculations.
First, some definitions. Direct charges are those expenses that can be easily linked to specific programs and services. Food for preschool students is a good example of a direct cost. So is the expense of the preschool teachers' salaries.
By contrast, indirect costs are those expenses that, while necessary, cannot be reasonably tied to specific programs and services. The preschool's executive director and the cost of the payroll service are classic indirect expenses (indirect costs are also known as administrative costs, general and administrative expenses, and indirect charges, among other terms).
There is a bit of a where-do-we-draw-the-line question here. While food and teachers' salaries are clearly direct expenses, what about copy paper? Technically, the answer is that the paper and other supplies used by and for direct-service employees, such as teachers, are direct costs, while those used by the CEO or for administrative purposes are indirect.
No problem. All we need to do is give everyone a coded copy machine identifier that automatically attributes any copies they make to their own department. But what about the cost of the toner cartridge, that pricey intergalactic piece of plastic and metal that always runs low just before you need to make 25 copies of an urgent 75-page report? No problem here, either. Just calculate the total number of direct copies and the total number of indirect, take the percentages and charge the applicable percentage of the toner cartridge cost to direct and indirect charges. But what about the ink supply? It's a color copier, and the direct service people are always making color copies, which takes more of the most costly kind of ink. Okay, we'll fix that by calculating the number of color copies produced by direct and indirect users. Then we'll multiply the cost of the colored ink by the total percentages of direct and indirect users. Then we'll…
You can see where this is going. Theoretically, it is possible to turn every indirect cost into a direct cost just by keeping track of a number of extra variables. But this process of endless reductionism reaches an absurd level quickly. Sure, it may be possible to turn everything into a direct cost but at what expense? The hassle factor associated with this potentially endless process says we need to find a different way of calculating and charging indirect costs.
This is the point of the indirect cost rate. The idea is to come up with a reliable way of attributing—or allocating—indirect costs to direct service efforts. That way, each program or service can be assured that it will be asked to carry its fair share of the administrative burden. Budget makers usually have some type of indirect cost allocation policy to guide them.
But the key question is how that allocation is derived. As it happens, there are many ways of getting there. Here are a few of the most common.
Percentage of Personnel
The simplest and perhaps most common method of allocating indirect costs is to figure out the percentage of total personnel costs for which each individual program is responsible and then apply it to the total of all indirect costs. This is Math 101 stuff—if a program uses 40 percent of all personnel, it gets charged 40 percent of the total indirect costs. The argument here is that, because personnel tend to be the biggest high-maintenance item in any budget, indirect or administrative costs will probably flow proportionately to heavy concentrations of personnel.
Percentage of Expenses
Then there is another simple formula, which we will call the percentage of expenses formula. You get this one by calculating the total percentage of spending on personnel and other direct expenses that each program incurs, then multiplying it by the total of all indirect costs. If my program is responsible for 27 percent of all expenses, then my share of the indirect cost is 27 percent. This one carries the percentage-of-personnel formula a step further by assuming that personnel are just one indicator of spending on indirect items and that the true measure of indirect effort is a combination of personnel and other direct costs.
The Federal Method
For frequent flyers on the federal dollar, the folks in Washington have a special program. Recognizing that it was getting tiresome to set up an indirect rate for every contract or grant with the federal government, the federal government many years ago established a policy of setting up a single overhead rate that would apply to all federal government–related business. Guidance on the acceptable ways of doing this can be found in Office of Management and Budget Circular A-122 (OMB A-122) Cost Principles for Nonprofit Organizations.
Secrets of the Indirect Cost Game
What these methods all share is that they represent a uniform, predictable method for calculating overhead costs. In fact, it's the uniform and rational application of the method that is as important as the results themselves, because otherwise the allocation of indirect costs becomes an exercise in arbitrariness. A sure sign of trouble is when the chief financial person starts to apply different standards for overhead charges to different programs—retroactively. This practice amounts to changing the rules of the game after it's been played.
Speaking of games, the whole area of indirect costs is a treasure trove of gamesmanship. And even when games aren't being played, the mechanics of overhead calculations can produce some intriguing results. Thus, we enter the funhouse world of indirect cost reporting.
We once had conversations with two different nonprofit managers, who were quite pleased that their organizations routinely post administrative costs of close to 8 percent. “We try to put the money into direct care,” said one.
A laudable sentiment, to be sure. On the other hand, is there any nonprofit manager out there whose organization seeks to spend money on overhead expenses instead of direct service? Like most such assertions, this one was as much an expression of philosophy as a statement of fact. From what we knew of both organizations, they certainly did not overspend on administrative costs. On the other hand, they were not cold-water-bathrooms-60-watt-bulbs-and-reuse-the-teabag-types either.
Ironically, just a few miles away from where one of the CEOs sat was a major research-intensive university that we happen to know carries a routine overhead rate of more than 100 percent. And while we have never asked, we suspect that that organization would also say it likes to keep its overhead low and put most of its funds directly into education.
How can one explain this seeming paradox? Is it really true that two nonprofits can have such dramatically different overhead rates? Who's mistaken here?
Defining and Calculating Indirect Costs
The puzzling answer is that there is no mistake. They are both right, each in its own way. For its part, the vast majority of the university's buildings are relatively no more opulent than those of the smaller nonprofit. And although the university does generally have a much larger overhead structure, it's certainly not 12.5 times larger, as its 100 percent overhead rate would suggest. So why are they both right?
The answer lies in how you define and then calculate indirect costs. Exhibit 14.2 shows a highly simplified nonprofit organization budget based on two programs and various related expenses. What is the entity's indirect cost rate? If you said 10 percent, you would be right. If you said 71 percent, you would also be right. And if you gave a variety of other percentages, you would probably be right as well, because it all depends on how you define indirect costs.
Exhibit 14.2 Direct Costs
| Item | Dollars |
| CEO | $60,000 |
| Program managers (2) | 80,000 |
| Administrative assistant (1) | 25,000 |
| Direct service staff | 200,000 |
| Payroll taxes and benefits (22% of salaries) | 80,300 |
| Direct supplies | 40,000 |
| Program rent | 10,000 |
| Administrative rent | 5,000 |
| Vehicle costs | 5,000 |
| Miscellaneous | 2,000 |
| Total | $507,300 |
Here's how we get those two very different results. In Exhibit 14.3, we try to make every conceivable expense a direct charge. So we argue that the CEO, normally an indirect cost, spends half of her time supervising the two program directors. The administrative assistant is said to spend a third of his time dealing with indirect matters, and we accept the full charge for rental of the administrative space.
Exhibit 14.3 10%—Aggressive Computation of Indirect Costs
Formula: Indirect costs are drawn from the shaded areas. Based on this example, that means:
|
|
| Item | Dollars |
| CEO | $60,000 |
| Program managers (2) | 80,000 |
| Administrative assistant (1) | 25,000 |
| Direct service staff | 200,000 |
| Payroll taxes and benefits (22% of salaries) | 80,300 |
| Direct supplies | 40,000 |
| Program rent | 10,000 |
| Administrative rent | 5,000 |
| Vehicle costs | 5,000 |
| Miscellaneous | 2,000 |
| Total | $507,300 |
In Exhibit 14.4, we define indirect expenses extremely broadly. This is what happens in federal funding (like what our university gets), where recipient organizations must charge a federal overhead rate based on a specific formula. It's also related to why the Pentagon used to be accused of things like buying $80 screwdrivers ($6.00 for the screwdriver and a $74.00 automatic overhead charge on every order). In this computation, we express the rate as a percentage of direct costs, not on the total budget as in the first example, which drives the rate even higher.
Exhibit 14.4 71 Percent—Broad Computation of Indirect Cost
| Item | Dollars |
| CEO | $60,000 |
| Program managers (2) | 80,000 |
| Administrative assistant (1) | 25,000 |
| Direct service staff | 200,000 |
| Payroll taxes and benefits (22% of salaries) | 80,300 |
| Direct supplies | 40,000 |
| Program rent | 10,000 |
| Administrative rent | 5,000 |
| Vehicle costs | 5,000 |
| Miscellaneous | 2,000 |
| Total | $507,300 |
Why It Matters
As we noted, the general public believes that indirect costs in a nonprofit are inherently bad and should be minimized or eliminated altogether, and we have to go along or risk losing funding or credibility. So we attempt to creatively define indirect costs out of existence.
But the real problem is that by claiming our indirect rates are rock-bottom low, we are subtly devaluing the work of management and misleading ourselves if we take our press releases too seriously. That will be an even bigger problem in the future because the demands of the external environment are forcing the cost of management up, not down. Greater use of technology, the need to do more fund-raising, and the overall cost of doing business all drive indirect costs up. Those who truly believe they can get away with less and less spending in this area are simply being shortsighted.
Yet the tension will continue. The average donor, empowered with more and more publicly available information about nonprofit recipients, will demand low indirect costs as a condition of philanthropy. Media outlets will simply endorse the responsible-sounding philosophy.
The pressure to report low indirect costs will not go away. Considering the relative lack of other structural pressures on nonprofits, this may very well be healthy for the sector overall. But that doesn't mean individual nonprofit managers should take their own press releases too literally. They must find a way to honestly report competitively low indirect costs even as they pay more and more attention to management matters. That can be our little secret.