INDIRECT COST: Meaning, Rate, Grant & Difference

Businesses can allocate indirect costs in a variety of ways. While they may not always be suited for achieving a specific goal, they can nevertheless have an impact on future business decisions and who the company expects to bring on as a customer. Even though indirect costs differ by industry, it is critical to identify the price of these charges to efficiently manage operations and plan for any future indirect costs that may develop. In this post, we describe an indirect cost and its rate, as well as present an example of one that you may be required to pay, and also, distinguish between direct vs indirect costs and grants.

What Is Indirect Cost?

An indirect cost is defined as business expenses that cannot be directly linked to any grants, contracts, project function, or activity but are required for the organization’s overall operation and the performance of its activities. In theory, if little meters could record minutes in a cross-cutting fashion, costs such as heat, light, accounting, and people might be invoiced immediately. Such a method is impractical due to practical constraints. Cost allocation plans or indirect cost rates are therefore utilized to disburse those costs to income sources that benefit from them.

In other words, indirect costs are those that are not regarded as direct costs. Direct expenses can be associated with specific cost objectives such as a grant, contract, project, function, or activity. Direct costs often include:

Wages are salaries (including vacations, holidays, sick leave, and other excused absences of employees working specifically on objectives of a grant or contract – i.e., direct labor costs).
Further employee fringe benefits are available to direct labor employees.
Consultant services contracted to achieve specified grant/contract objectives.
Employee (direct labor) travel.
Directly purchased materials, supplies, and equipment for use on a specific grant or contract.
Communication expenses such as long-distance phone calls or telegrams associated with a certain award or activity.

Example of Indirect Cost

An indirect cost example includes supplies, utilities, office equipment rental, desktop computers, and cell phones. Indirect costs, like direct expenses, can be constant or variable. Fixed indirect costs include expenses like rent, whereas variable indirect costs include changeable charges like electricity and gas.
In general, for-profit corporations consider “fringe benefits,” like paid time off and the use of a company automobile, to be indirect costs.

Indirect Cost Rate

An indirect cost rate is essentially a technique for establishing what shares of Departmental/organizational administration costs each program should bear fairly and conveniently, within the bounds of acceptable administrative principles. After removing or reclassifying unallowable costs and unusual or distorting expenditures, an indirect cost rate is the ratio of total indirect costs to beneficial direct costs (i.e., capital expenditures, major contracts, and grants).

The indirect costs in the numerator of the equation should be related to the direct expenses in the denominator in a sensible way. This will enable each program or activity represented in the direct cost base to assume its fair share of indirect costs when the rate is applied.

How is the Indirect Cost Rate Determined?

Based on an indirect cost proposal submission, the cognizant federal agency is responsible for authorizing indirect cost rates for receivers. The indirect cost proposal or cost allocation strategy should include the following:

List all of the Department or unit’s operations and their associated expenditures. Regardless of the funding source used to pay for them, all activities must be included.
Provide a rate for the costs that were allocated to departments or units through the central service cost allocation plan.
Determine whether the actions and their expenses are direct or indirect.
Remove capital expenditures and those specified as unallowable by OMB Circular or program legislation from indirect costs.
Determine the rate by dividing the total remaining indirect costs by the direct cost base chosen for indirect cost distribution. Modified Total Direct Costs(MTDC) is the most commonly utilized base. The determining criterion is whether the cost in question generates overhead or benefits from indirect costs, in which case it should be reclassified to the base and awarded a fair proportion of indirect costs. How to obtain an approved indirect cost rate is covered in more detail below.

For nonprofit organizations, go to the US Department of Labor’s website and click on the Indirect Cost Proposal Guidelines page.
Frequently asked questions regarding how to develop your indirect cost proposal for those covered by OMB Circular A-87 for state and local governments. (Excerpt from “1998 U.S. DEPARTMENT OF EDUCATION Indirect Cost Determination Guidelines for State and Local Government Agencies” (Blue Book)).

If you have any questions about indirect costs, please contact the Indirect Cost Division at IndirectCostDivision@ed.gov.

Federally- or State-Approved Indirect Cost Rate

The HHS Indirect Cost Rate Group will honor federal or state-approved rates. To support the given indirect cost rate, additional documentation may be required.

Entities must submit the HHS Indirect Cost Rate Group with a copy of the current authorized negotiated indirect cost rate agreement. The agreement must be supplied within 30 days, or the request will be canceled, and indirect charges may be prohibited.

When the federally-approved indirect cost rate is accepted by the HHS Indirect Cost Rate Group, an acknowledgment letter will be provided to the sub-recipient to confirm acceptance and use of this rate.

After a rate is accepted, it remains in force until the entity seeks a new rate or notifies HHS of changes to the existing rate. When your federal or another state agency-approved rate(s) change, you must notify the HHS via the Federal Funds Office Landing Page for Subrecipients within 30 days of the change.

If your federal or state agency has not authorized your rate before it expires, organizations should submit a technical help request via the Federal Funds Office landing page for sub-recipients.

Indirect Cost Rate Negotiation

Negotiating a rate necessitates submitting an indirect cost rate proposal and supporting documents to the HHS Group. When requesting a negotiated rate, entities must fill out the HHS templates.

A negotiated rate must be acquired if the company intends to use unrecovered indirect costs as a match or for cost sharing. The indirect cost amount is used to establish how much of the indirect cost the organization can utilize for cost sharing or as a match. HHS approval is required in advance.

The indirect cost rate proposal must be submitted to HHS via the Federal Funds Office Subrecipient Landing Page.
After the indirect cost rate is approved, an indirect cost rate agreement is issued. The indirect cost rate agreement specifies the due date for the entity’s subsequent proposal.

Types of Rates

To assist in recouping indirect costs, HHS offers a variety of rate categories. These choices are accessible to entities requesting a negotiated rate. In the notice of funding opportunity for each state or federal grant, any restrictions on indirect costs can be discovered.

#1. Provisional Rates:

The primary rate type produced by the HHS is provisional rates. Provisional rates are short-term approximations of the indirect cost rate. Provisional rates must be determined annually to determine the final real amounts. A final rate is established once a provisional rate is trued up.

#2. Final Rate:

Once the actual costs for the fiscal year are determined, a final rate is calculated. After the true-up process is completed after the provisional rate period, final rates are issued. A final rate cannot be changed.
Final rates are used to alter alleged indirect expenses and may include a refund or reimbursement if the final rate is less or more than the preliminary rate.

#3. Fixed Carry-forward:

A fixed carry-forward rate is an indirect cost rate with the same characteristics as a predetermined rate, except that the difference between the estimated costs and the actual, allowable costs of the period covered by the rate is carried forward as an adjustment to the rate computation of the following period. When the actual costs for this time are known, an adjustment will be made to the rate for a future year or years to compensate for the difference between the costs used to set the fixed rate and the actual costs.

#4. Predetermined Rate:

A predetermined rate is based on expected costs for a current or future period. Based on the entity’s actual indirect costs, a predetermined rate is applied. A predefined rate can only be provided if there is a high degree of certainty that it will not be exceeded.

Unless in exceptional situations, the fixed rate cannot be changed. If the entity’s total expenditures increase or drop by more than 25% within 90 days of the predetermined rate, the entity must submit a rate proposal. The proposed rate is based on the new spending data resulting from the increase or decrease.

Direct vs. Indirect Cost

There is a simple way to categorize payments as direct or indirect costs: Direct costs are the costs of generating, developing, and delivering a product or service, whereas indirect costs include expenses that are unrelated to a specific product.

Direct costs

Manufacturing materials
Equipment
raw materials
Labor costs Other production costs

Indirect costs

Utilities
Office Supplies
Office equipment
Campaigns for marketing
Accounting and payroll software
Employee

The Importance of Understanding the Distinction Between Direct and Indirect Costs

Furthermore, by tracking direct and indirect costs, you will gain a better understanding of your accounting and be better prepared to plan for the future.

While paying your taxes, you must also understand the distinction between direct and indirect costs. Certain direct and indirect costs are tax deductible. Repairs to your business equipment, such as your production line, are examples of tax-deductible direct costs. Rent, electricity, and some insurance fees are examples of tax-deductible indirect costs. But, each company’s position is unique. Contact your accountant or bookkeeper to determine whether costs are eligible.

How Do Direct and Indirect Costs Affect Small Business Funding?

Identifying direct and indirect costs is especially crucial in cases of government grants or other sources of external assistance. Grant guidelines are frequently rigorous about what constitutes direct or indirect costs and may grant a specified amount of funding to each classification.

Often, funding for a certain project will support primarily direct costs. Certain government organizations may allow you to explain why indirect costs should also be supported, but the decision to award grants is entirely up to them.
When a corporation accepts government assistance, the funding agency may also impose severe regulations on the maximum indirect cost rate and the items that count as indirect costs.

Classifying Direct and Indirect Costs for Proper Accounting

Knowing the distinction between direct and indirect costs is an important component of proper accounting. Monitoring each type of cost individually can help small businesses understand their cash flow, effectively price their items, and maximize their tax deductions. If you need help, get a professional accountant or use accounting software that can help you break down your business’s expenses.

What is indirect cost and what examples?

Indirect costs include overhead expenses (for example, rent and utilities) and general and administrative expenses (for example, officers’ salaries, accounting department costs, and personnel department costs).

What are indirect costs in business?

Indirect costs are business expenses that are not easily associated with a specific grant, contract, project function, or activity but are required for the organization’s overall operation and the performance of its activities.

What are the 5 types of indirect costs?

Provisional, predetermined, and fixed with carry-forward are the three types of indirect costs.

What are the 4 types of cost?

Fixed costs, variable costs, direct costs, and indirect costs are the four basic categories into which costs are divided.