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Indirect Cost Allocation Basics


March 1, 2012 by FCS GROUP
Category: Finance Advisor

This Advisor column was originally published in March 2011.

By Peter Moy, Principal, FCS GROUP

Local governments have overhead and administrative costs essential to operating the government and providing services to the public. Examples include costs incurred for a city council, a board of commissioners, a city manager or county administrator, human resources, financial management, government facilities, insurance, purchasing, records management, and information technology. These costs are usually funded by a jurisdiction's general fund, but a jurisdiction has many other types of funds that provide a variety of services that use these administrative and overhead resources. These indirect services are provided to the jurisdiction's operating departments such as police, fire, parks and recreation, development services, public works, library, and utilities.

Over the past year a number of cities and counties have focused on how they allocate their general fund indirect costs or their administrative costs to other funds and services. For some, their review of cost allocation practices is a response to their audit by the State Auditor's Office. Over the years, we have encountered a variety of different methods for allocating these general fund indirect costs to enterprise funds, other funds, and services. For example, allocations are limited only to enterprise funds; or administrative staff (e.g. finance staff) are budgeted in and charged to different funds and services based on time estimates of their efforts spent working in those areas. These types of allocations are usually partial allocations, use undocumented time estimates, are not related to measurable factors, and are not updated annually. There are also cities and counties that have formal and more complete indirect cost allocation plans that are prepared every year and document their allocation of costs.

So, why have a formal indirect cost allocation plan? A formal indirect cost allocation plan can help a jurisdiction do the following:

  • Identify the actual cost of all services,
  • Reimburse service providers for estimated or actual costs incurred to deliver internal services,
  • Calculate cost-based user fees for public services such as development review, parks, administration, or any service where the user pays all or part of the cost directly, and
  • Recover central services costs through federal program reimbursement based on the Office of Management and Budget A-87 guidelines.

To prepare an indirect cost allocation plan there are six basic steps.

  1. Evaluate the organization: Categorize the departments and funds as direct or indirect services; identify within indirect service departments any distinct program areas of service (e.g. payroll, accounts payable, utility billing); and identify any indirect services provided by direct service departments and vice-versa (e.g. public works or parks providing facilities and grounds maintenance activities for all buildings).
  2. Utilize available budget or actual financial information: Compile the total costs related to indirect services as described in the most recent budget or actual expenditures.
  3. Determine allocation factors: Form the basis for allocating indirect service costs by gathering the most recent available data sets or easily estimated workload measures consistent with the expenditure year, such as square footage or number of full time equivalent positions. (Key point: Only use data sets that can be easily gathered in subsequent updates to keep the allocation plan current.)
  4. Make adjustments: Adjust for any costs that should not be allocated, costs that can be assigned directly, and any other agreed upon revisions that do not diminish the “cost-basis” of the plan.
  5. Allocate costs: Allocate indirect costs using a one or two step methodology depending on the complexity of the organization and the levels of indirect services included in the plan and based on each department's proportionate share based on the workload measures/allocation factor for each indirect cost pool.
  6. Calculate full cost overhead: Identify each direct service's full share of indirect costs.

While preparing the plan, consider the following principles concerning indirect cost allocation:

  • Remember that cost allocation is, by definition, an estimate and can be debatable,
  • Strive for a reasonable and equitable means to allocate costs,
  • Use real and current costs,
  • Establish cost allocation measures that are real and current, and
  • Use allocation measures that reasonably link to the level of service and/or benefit received, or at least represent an acceptable means for apportioning the costs.

As local governments continue to struggle with the challenge of limited general fund resources, a formal and well documented indirect cost allocation plan can help assure that all funds and services contribute their fair share of a jurisdiction's general fund administrative and overhead costs. A jurisdiction without a formal plan or that allocates costs without appropriate documentation does not know whether it is recovering its fair share of costs and might also be more susceptible to State Auditor findings related to its allocated costs to other funds.

About FCS GROUP

FCS GROUP writes for MRSC as a Finance Advisor.

FCS GROUP, established in 1988, is an independent financial consulting firm that provides economic, public finance, management consulting, and financial (rates, charges, and fees) services to public sector clients inclusive of city and county governments, utilities, municipal corporations and ports, special purpose districts, and state agencies. Since the firm’s inception, FCS GROUP has delivered high-quality, cost-effective consulting services in over 2,300 engagements and served more than 525 clients. Their staff serves clients throughout the western United States and Canada from locations in Redmond, Washington and Lake Oswego, Oregon.

The views expressed in Advisor columns represent the opinions of the author and do not necessarily reflect those of MRSC.

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