Constructing an Effective Cost Allocation Plan

by Jill A. Shaw, CPA, Partner

Posted on April 15, 2013

Cost allocation is important because, when it’s done accurately and consistently, it can provide a realistic picture of what expense is required to run a program. Another important function is to assist users of your organization’s financial information to make informed decisions.

First, Consider the Users of the Plan

A cost allocation performed for grant reporting or program evaluation purposes may or may not be appropriate for external (GAAP) financial reporting. For example, a cost allocation to determine program viability may include all costs as program costs, even though some costs by nature should be classified as supporting services (such as administrative salaries and audit fees).

In addition, government grant allocation may allow the organization to pool all indirect costs and charge them to the program based on a computed indirect cost rate. However, such methods might not result in a reasonable allocation of indirect costs from a GAAP standpoint. In all cases, nonprofit organizations must take steps to ensure they are billing only allowable costs and building accurate overhead costs into contracts and grants.

Direct vs. Indirect Costs

In developing a cost allocation plan, you must first identify their direct and indirect costs.

Indirect costs are those costs that are not easily identifiable with a specific program, but frequently benefit more than one program. Common examples of indirect costs include the Executive Director’s salary, facility rent, and administrative supplies. For example, if an organization houses all three of its programs in one leased facility, the cost of rent is an indirect cost, meaning that since there are not three separate leases, they will have to find a way to estimate the relative benefit each program receives from being housed in that location.

Direct costs are those that can be specifically identified with a particular program. The salary of an employee whose efforts can be directly identified with a particular program is a prime example of a direct cost.

Selecting An Allocation Base

Once indirect costs are identified, you must then determine the basis of allocation. A cost allocation base is the element that best measures the relative benefits received by a particular program.

When selecting a base, consider one that is accurate, yet will not require too much time to implement. If your organization provides specific client services such as drug recovery counseling, you can consider selecting a more general cost allocation basis (e.g., number of patients).

A couple of the most common allocation bases are:

Payroll: Allocations are based on a percentage of the total payroll dollars charged by employees to each program.

Square footage: Allocations are based on the proportionate space occupied by each program in your office or worksite. This method is useful for allocating rent and utilities.

Necessary: Elements of a Plan

You might have to pick and choose which method works best for your organization. Whatever method you decide to use,  you should use it consistently, put it in writing, and have it approved by management and/or the proper grant officials. The organization should also have a process to update the plan periodically.

Allocation can look complicated at first glance, and it can be challenging to set up a reliable, consistent and simple system. Nevertheless, with proper planning you can develop a method that works for you and that reflects the reality of what happens in your organization from day to day.