What Are Indirect Costs?
Indirect costs, sometimes called overhead or administrative costs, are expenses incurred to support the overall operations of an organization rather than specific programs or projects. These costs benefit multiple activities or objectives simultaneously, making it difficult to assign them directly to any single cost objective.
Examples of indirect costs include human resources, accounting and auditing services, office supplies, insurance, utilities, and general administration. These costs are necessary for the smooth functioning of the organization, but do not directly deliver programmatic services. For instance, a nonprofit literacy program’s direct costs may include salaries of tutors, reading materials, and facility rent for classrooms. Meanwhile, indirect costs cover shared support functions like information technology services, administrative salaries, and building maintenance.
The Code of Federal Regulations (CFR), specifically Section 200.56, defines indirect costs as those “incurred for a common or joint purpose benefitting more than one cost objective, and not readily assignable to the cost objectives specifically benefited, without effort disproportionate to the results achieved.”
Understanding this distinction is critical because it affects how nonprofits allocate expenses in their financial reporting and funding requests.
Why Calculating Indirect Cost Rates Matters for Nonprofits
Nonprofits rely on various funding sources, including private donations, fundraising events, grants from governments or foundations, and sometimes direct founder funding. Regardless of the source, funders expect transparency and accountability regarding how their money is spent.
An accurate indirect cost rate calculation ensures nonprofits appropriately allocate overhead expenses, demonstrating responsible stewardship of funds. It helps organizations:
- Show funders that resources are being used efficiently and effectively.
- Secure sufficient funding to cover both direct program expenses and necessary overhead.
- Make informed financial and operational decisions.
- Prepare accurate and audit-ready financial statements.
Failing to account for indirect costs adequately can jeopardize an organization’s financial stability. Without a clear understanding of overhead expenses, nonprofits risk underfunding essential support services, which may hamper their ability to deliver programs and fulfill their missions.
Accurate indirect cost rates also support grant compliance. Many funders impose restrictions or caps on indirect cost reimbursements, and having a transparent allocation methodology helps nonprofits justify their expenses during audits or reviews.
Common Challenges in Calculating Indirect Cost Rates
Calculating the indirect cost rate is complex for many nonprofits due to several factors:
Lack of Universal Standards
There are no universally mandated methodologies or standards for allocating indirect costs across nonprofits. Different funders may have varying guidelines, allowable expenses, and rate caps, which can complicate the process.
Diverse Funding Requirements
Nonprofits often receive funds from multiple sources, each with unique rules on what constitutes allowable indirect costs and how to calculate and apply indirect cost rates.
GAAP Limitations
Generally Accepted Accounting Principles (GAAP) do not provide specific guidance on indirect cost allocation, leaving nonprofits to develop their policies or rely on funder requirements.
Administrative Burden
Funders may request detailed explanations or adjustments to indirect cost rates, increasing the workload on nonprofit finance teams. The administrative effort to track, document, and allocate costs precisely can be considerable.
Rate Caps and Recovery Limits
Many grants impose caps or limits on indirect cost reimbursement, which can restrict a nonprofit’s ability to fully recover overhead expenses. This often forces organizations to subsidize indirect costs through unrestricted funds or fundraising.
Potential Impact on Growth
When indirect cost rates are artificially capped or underestimated, nonprofits risk entering a “starvation cycle” where insufficient overhead funding limits organizational capacity, infrastructure development, and sustainable growth.
Understanding these challenges helps organizations recognize the importance of careful planning and adopting clear cost allocation policies to improve financial health and funding success.
Defining Key Terms: Direct Costs, Indirect Costs, and Indirect Cost Rate
To navigate indirect cost calculations successfully, nonprofits must understand key financial terms related to cost allocation.
Direct Costs
Direct costs are expenses that can be specifically identified with a particular program, project, or activity. Examples include salaries of program staff, materials used exclusively for a project, and rent for a facility used solely by one program.
Sometimes, direct costs benefit multiple programs; in these cases, they are called shared direct costs and must be allocated proportionally.
Indirect Costs
Indirect costs support common or shared objectives and cannot be readily linked to a single cost objective. Indirect costs may include:
- Overhead costs such as facilities, equipment, and program support staff.
- General and administrative (G&A) costs like finance, executive leadership, and human resources.
- Facilities and administrative (F&A) costs encompass building depreciation and maintenance as well as administration.
Indirect Cost Rate
The indirect cost rate is a percentage expressing the ratio of indirect costs to direct costs. It is calculated by dividing the total indirect cost pool by the total direct cost base.
Indirect Cost Rate = Indirect Cost Pool ÷ Direct Cost Base
For example, an indirect cost rate of 34% means that for every dollar of direct cost, the organization incurs 34 cents in indirect costs.
The indirect cost rate is often established through negotiations with funding agencies or grantmakers and may be documented in agreements such as a Negotiated Indirect Cost Rate Agreement (NICRA).
Reasonable, Allocable, and Allowable Costs
When calculating indirect costs, it is important to ensure all qualifying costs meet three criteria: reasonable, allocable, and allowable.
Reasonable
Costs must be necessary and consistent with the organization’s mission and operations. They should be ordinary and justifiable expenses for carrying out programs.
Allocable
Costs must be connected to a cost objective and proportional to the benefit received. This means the cost should relate to the program or activity it supports.
Allowable
Costs must comply with funder rules and regulatory standards. Allowable costs meet specific requirements established by funding bodies such as government agencies or foundations.
Certain expenses, like fundraising activities, lobbying, or direct solicitation of additional funds, are typically considered unallowable and excluded from the indirect cost pool.
Allocation Methods for Nonprofit Indirect Costs
Nonprofit organizations must adopt a fair and consistent method for allocating indirect costs. Because these costs benefit multiple programs, determining how to assign them across cost centers requires thoughtful consideration. The method chosen must reflect the relative benefit that each program receives from the indirect cost pool.
While there is no single correct method, the one selected must be reasonable, equitable, and consistently applied. Proper documentation of the allocation method is also essential to ensure compliance with funder requirements and support audit readiness.
Direct Allocation Method
In this approach, all costs that can be directly assigned to a program or activity are charged accordingly. Shared costs are proportionally divided using an appropriate basis such as square footage, hours worked, or usage metrics.
For example, a shared rent expense might be divided based on the square footage each program occupies. If Program A occupies 60 percent of the facility and Program B occupies 40 percent, the rent would be split accordingly. If part of the facility is used for administrative purposes, the proportional cost is allocated to the indirect cost pool.
This method works well for organizations where most costs can be assigned to programs using a measurable and consistent basis.
Simple Allocation Method
Also known as the single-rate method, this approach is used when all programs benefit equally from indirect costs. A single indirect cost rate is calculated and applied to each program based on its share of direct costs.
This method is best suited for smaller organizations or those where programs are of similar size and complexity, making a uniform allocation fair and accurate.
For instance, if a nonprofit has three programs and incurs equal levels of overhead to support each one, a simple allocation based on total direct costs can be used. Each program would then be allocated a proportional share of indirect costs using a single rate.
Multiple Allocation Base Method
This method involves using different bases to allocate various components of indirect costs. It is more complex but also more precise. For example, fringe benefits might be allocated based on salaries, while facility costs might be allocated using square footage, and administrative costs based on full-time equivalent staff.
This method is ideal for larger organizations with diverse programs and varying levels of support needs. It allows a more nuanced distribution of costs but requires careful data collection and robust accounting systems to support the calculations.
The multiple base method can also be broken down into:
- Two-rate allocation: separating fringe benefits and overhead.
- Three-rate allocation: breaking out fringe, overhead, and general administration costs.
Step-by-Step Process for Calculating Indirect Cost Rates
Once an organization selects an allocation method, it must implement a structured process to accurately calculate its indirect cost rate. The process involves collecting financial data, identifying costs, establishing cost centers, and applying the chosen method of allocation.
Gather Financial Data
The foundation of an accurate indirect cost rate calculation is reliable and comprehensive financial data. This includes:
- Income and expense reports
- Detailed program budgets
- Staff timesheets and work logs
- General ledger entries
- Documentation related to grants and funding agreements
Accurate recordkeeping ensures that expenses are classified properly and that cost centers are defined clearly.
Define Funded Programs and Cost Centers
Each distinct activity or service provided by the organization should be categorized as a program. These can be aligned with funding sources or grant terms. Cost centers should also be created for general and administrative activities and any fundraising or unallowable functions.
Separating cost centers makes it easier to determine which costs are direct and which are indirect. It also supports more accurate financial reporting and auditing.
Identify Direct and Indirect Costs
Review all expenses in the general ledger and classify each one as either direct or indirect. Add annotations explaining the classification where needed.
For example:
- Salaries for program-specific staff are direct costs.
- The executive director’s salary is an indirect cost unless the director spends a measurable portion of time directly managing a program.
- Utilities that serve the entire facility are indirect costs.
- Program-specific supplies are direct costs.
All shared expenses must be reviewed to determine if they should be allocated to multiple programs or charged to the indirect cost pool.
Select and Apply the Allocation Method
Once costs are identified, apply the chosen allocation method. Whether using a direct allocation model, simple allocation, or multiple base method, the allocation should reflect the real-world benefit derived by each program from the indirect services.
For example, if utilities cost $50,000 annually and the facility is used 50 percent by Program A, 30 percent by Program B, and 20 percent by administrative offices, the utility expense would be allocated accordingly across those cost centers.
Ensure that any cost base used, such as square footage or salary totals, is consistently applied throughout the allocation.
Allocate Staff Salaries and Shared Costs
Staff compensation is often the largest expense for nonprofits. Accurately allocating salaries requires clear documentation of how employees spend their time. Do not allocate based on job titles alone.
If an executive director spends 25 percent of their time managing a specific program, that portion of their salary should be allocated as a direct cost to that program. The remaining 75 percent would be allocated as an indirect cost.
Similarly, shared costs such as office equipment or communications tools should be allocated based on usage or another fair basis.
Allocate Unallowable and Joint Costs
Some costs, such as fundraising and lobbying, are unallowable and must not be included in the indirect cost pool. However, these expenses must still be tracked and reported in the general ledger.
For joint costs that benefit both fundraising and programmatic activities, clear criteria must be met to determine whether any portion of the expense can be allocated to programs. These criteria include:
- The message must include a specific call to action.
- The content must be educational and support the nonprofit’s mission.
- The audience must be equipped to respond to the message.
If these conditions are met, a portion of the joint cost may be allocated as a program expense.
Finalize the Indirect Cost Rate
After all costs have been allocated, the indirect cost rate can be calculated. The standard formula is:
Indirect Cost Rate = Total Indirect Costs ÷ Total Direct Costs
Suppose a nonprofit has total indirect costs of $300,000 and total direct costs of $900,000. The indirect cost rate is 33.3 percent. This means that for every dollar spent on direct program activities, the organization incurs about 33 cents in indirect costs.
This rate can be used for internal planning, budgeting, and reporting, as well as for negotiating with funders and submitting proposals.
Maintain Documentation and Review Regularly
All assumptions, allocation bases, and calculations should be thoroughly documented. This ensures transparency and simplifies future audits or rate negotiations.
Review the allocation policies annually to adjust for changes in staffing, facilities, or program structure. Updating the cost allocation plan ensures the indirect cost rate remains accurate and fair over time.
Monitoring Allowable and Unallowable Costs in Non-Profit Organizations
Understanding the distinction between allowable and unallowable costs is essential for nonprofit organizations when calculating indirect cost rates. These classifications determine what expenses can be included in the indirect cost pool and ultimately affect reimbursement levels from funders and grantors. Accurate classification also ensures compliance with federal regulations and grant agreements.
In most cases, especially for organizations receiving federal grants, strict guidance is provided by the Office of Management and Budget. Nonprofits must be familiar with these regulations and stay current with changes in cost principles and allowable spending practices.
The Role of Allowable Costs in Indirect Rate Calculations
Allowable costs are those that meet certain established criteria under the relevant grant or funding agreement. To qualify as allowable, a cost must be reasonable, allocable, and compliant with both the funder’s rules and the nonprofit’s policies.
Allowable indirect costs can include:
- Administrative salaries that benefit more than one program
- Utility expenses shared across departments
- Depreciation of facilities and equipment used organization-wide
- Office supplies used by multiple teams
- General ledger, payroll, and HR support
These costs are recoverable through the indirect cost rate and should be allocated across programs and funding sources using a consistent methodology.
Unallowable Costs and Their Implications
Unallowable costs are expenses that cannot be charged to a federal award or included in the indirect cost pool for reimbursement. These are not necessarily inappropriate or unnecessary costs. They may be essential to the operation of the nonprofit. However, their recovery is restricted by regulatory guidelines or funding agency rules.
Common unallowable costs include:
- Lobbying and political advocacy
- Fundraising events and donor solicitation
- Entertainment and alcohol expenses
- Fines, penalties, and legal fees not related to grant activities.
- Costs incurred for personal benefit or non-business-related travel
- Contributions or donations to other organizations
Nonprofits must ensure these costs are tracked separately from allowable expenses. They should still appear in the general ledger for financial transparency, but must not be included in the indirect cost pool calculation.
Managing Joint Costs in Communications and Fundraising
A complex area of cost classification involves joint costs—expenses that benefit both programmatic and fundraising purposes. For example, a brochure mailed to potential donors may also serve to educate the public on the organization’s mission and activities.
In such cases, cost allocation must be supported by evidence that the communication meets specific conditions. According to accepted guidance, these conditions are:
- The message includes a call to action that aligns with the nonprofit’s mission
- The primary purpose is educational or service-related rather than solicitation.
- The audience is expected to act based on the mission-driven appeal.
If these criteria are met, a portion of the cost may be assigned to programmatic expense. If not, the entire amount must be classified as fundraising, making it unallowable.
Careful documentation is necessary to defend these allocations during an audit or funder review.
Building Cost Allocation Policies for Better Compliance
To manage indirect costs accurately and avoid compliance risks, nonprofits must develop and maintain a formal cost allocation policy. This policy outlines how expenses are categorized, allocated, and reviewed. It also defines roles, responsibilities, and procedures for staff involved in financial reporting.
A strong cost allocation policy includes:
- Definitions of direct, indirect, shared, and unallowable costs
- Clear criteria for classification and allocation methods
- Allocation bases used for different expense types
- Procedures for reviewing and approving allocations
- Frequency of updates and review cycles
Such a policy not only supports internal consistency but also enhances credibility with funders. It demonstrates a commitment to financial stewardship and regulatory compliance.
Conducting Regular Reviews and Internal Audits
Nonprofits should regularly review their allocation processes and classifications. Internal audits can uncover discrepancies, misclassified expenses, and inefficiencies in the reporting structure. Periodic reviews ensure that:
- The cost allocation methodology remains appropriate
- Staff are following defined procedures..
- New grant requirements are being integrated into the process.
- Unallowable costs are excluded from indirect cost pools.
Reviews should also verify that employee timesheets and expense reports are accurate. Errors in time tracking can lead to misallocations, jeopardizing the accuracy of the indirect cost rate and the integrity of funding agreements.
Maintaining Transparency in Grant Reporting
Funder confidence depends on clear, accurate, and well-supported financial reports. When indirect cost calculations are backed by consistent policies and careful cost tracking, nonprofit organizations can avoid disallowed costs and protect their funding sources.
Transparency requires:
- Comprehensive financial documentation
- Complete audit trails for all cost allocations
- Accessible reports that show how indirect cost rates were applied
- Justifications for any allocations involving joint or shared costs
Fulfilling these expectations allows nonprofits to build long-term relationships with funders and demonstrate their value as reliable stewards of public or private funds.
Keeping Current with Regulatory Standards
Nonprofits working with government grants, especially federal awards, are subject to evolving regulations. Key guidelines are issued by agencies such as the Office of Management and Budget, which publishes the Uniform Administrative Requirements, Cost Principles, and Audit Requirements for Federal Awards.
This uniform guidance outlines:
- Cost principles for both direct and indirect expenses
- Documentation requirements
- Thresholds for procurement and subrecipient monitoring
- Conditions for negotiated indirect cost rates
Staying current with these guidelines ensures the organization’s indirect cost strategy aligns with legal requirements and best practices. Organizations should assign responsibility for tracking changes in regulation to a finance team member or an external advisor.
Clarifying Funders’ Requirements
Not all funders follow the same rules. While federal grants typically allow for negotiated indirect cost rates, private foundations, local governments, and corporate sponsors may impose flat caps or restrict certain costs.
Understanding each funder’s expectations is crucial when applying for grants or negotiating agreements. Organizations should:
- Review grant terms thoroughly
- Clarify allowable expenses before applying.
- Request rate exceptions or adjustments if justified
- Avoid assuming that all indirect costs will be reimbursed.
In some cases, funders may require a specific cost allocation method or request periodic reporting on how funds were used. Being proactive in understanding and fulfilling these obligations minimizes disputes and delays in funding.
The Impact of Indirect Cost Caps on Financial Stability
Many nonprofits operate under capped indirect cost rates, often ten to fifteen percent of total direct costs. While this may appear reasonable, research suggests actual indirect costs often exceed these limits. One study found that some nonprofits operate with indirect rates closer to forty percent.
When funding agreements limit indirect recovery to artificially low levels, organizations are forced to use unrestricted donations or fundraising to cover shortfalls. This can trigger a cycle of financial pressure where the organization’s infrastructure suffers due to a lack of overhead investment.
Symptoms of underfunded indirect costs include:
- Outdated technology systems
- Staff burnout due to understaffing
- Limited capacity to evaluate programs
- Poor data collection and reporting systems
By accurately documenting their true indirect cost rates and negotiating higher reimbursement where possible, nonprofits can break this cycle and build more sustainable operations.
Leveraging Tools and Strategies for Indirect Cost Recovery
Nonprofit organizations that understand and implement best practices in indirect cost calculation are better positioned to negotiate favorable rates, maintain compliance, and ensure long-term sustainability. However, understanding the theoretical framework is only one part of the equation. Operationalizing these principles requires strategic investment in tools, clear processes, and a forward-thinking financial strategy.
Effective indirect cost recovery goes beyond basic cost allocation. It also involves negotiating rates with funders, maintaining robust internal systems, and adopting financial technologies that support transparency and efficiency.
The Role of Technology in Indirect Cost Management
Managing indirect costs manually can be overwhelming, especially for larger nonprofits or those with diverse program portfolios. Many organizations now rely on automated financial management tools to support real-time cost tracking, reporting, and analytics.
A comprehensive procure-to-pay system, for example, helps organizations:
- Capture complete and transparent spend data
- Classify and allocate expenses based on actual usage.
- Link financial operations with accounting records for consistency.
- Enable automated workflows for review and approval of expenses.
- Track actual versus budgeted spend across cost centers
These tools reduce human error, increase consistency in applying allocation rules, and allow for faster response during audits or funder reviews. In environments where multiple grants overlap, automated tracking ensures that shared costs are distributed accurately based on real-time input rather than estimation.
Building an Audit-Ready System for Indirect Cost Reporting
One of the most significant benefits of using modern financial software is the ability to prepare audit-ready reports quickly and accurately. Funders often require supporting documentation for any claimed indirect costs, and a centralized data platform allows nonprofits to respond efficiently.
Features that support audit readiness include:
- Time-tracking systems integrated with payroll and grant reporting
- Expense tagging that aligns with cost centers and funding restrictions
- Automated calculations of modified total direct costs
- Historical records of prior rate negotiations and cost policies
- Customized reporting dashboards that segment cost types
Having this structure in place not only supports compliance but also enhances an organization’s credibility in the eyes of funders, which is especially important when requesting a higher indirect cost rate.
Developing a Negotiation Strategy for Indirect Cost Rates
For organizations receiving federal funding or working with large private foundations, there is often an opportunity to negotiate the indirect cost rate. Entering these discussions with strong documentation and a clear understanding of your financial picture is essential.
To negotiate from a position of strength, a nonprofit should:
- Prepare a detailed cost allocation plan showing how indirect costs are distributed
- Present historical financial data to justify actual overhead levels
- Document the methodology used to calculate indirect costs.
- Demonstrate alignment with funder goals and accountability standards.
- Request a Negotiated Indirect Cost Rate Agreement if eligible.
Federal funders allow for a process known as a NICRA, which outlines a formally approved rate that the organization can apply across applicable awards. A well-prepared NICRA proposal includes:
- A complete set of financial statements
- Supporting documentation for cost allocations
- Identification of the cost base used (e.g., salaries, MTDC)
- Calculated rate and justification
- Organization chart and function descriptions
Once approved, this rate remains in effect for a designated period, helping nonprofits recover a realistic portion of their indirect expenses.
Understanding the “De Minimis” Rate Option
For nonprofits that have never negotiated an indirect cost rate with a federal agency, there is an option to apply a default rate of 10 percent of modified total direct costs. This is referred to as the “de minimis” rate and is allowed under Uniform Guidance rules.
While this rate is easy to apply and requires minimal documentation, it may not reflect the actual overhead burden carried by the organization. Smaller nonprofits, in particular, often face higher indirect costs due to limited economies of scale.
If actual overhead exceeds the de minimis rate, it is often in the nonprofit’s best interest to negotiate a higher rate through the NICRA process or to explore unrestricted funding to fill the gap.
Creating Sustainable Cost Structures
Nonprofits must consider sustainability when setting internal financial strategies. Overreliance on restricted funding or inconsistent overhead recovery creates financial fragility. A sustainable cost structure includes:
- Accurate calculation of indirect cost rates
- Diversification of funding sources
- Transparent policies for cost classification and recovery
- Investment in infrastructure to support growth and efficiency
Funders increasingly value transparency and capacity-building. Nonprofits that invest in strong administrative systems are better able to deliver results, meet compliance expectations, and demonstrate impact.
This means that building a realistic and fully justified indirect cost rate not only supports operational needs but also strengthens the organization’s overall value proposition.
Communicating the Value of Indirect Costs to Funders
One challenge nonprofits often face is the perception that indirect costs are unnecessary or wasteful. To overcome this, organizations must effectively communicate how indirect costs support mission-critical work.
This includes explaining that indirect costs cover:
- Essential management and oversight
- Compliance with legal and financial standards
- Training and development for staff
- Data collection and program evaluation
- IT infrastructure, security, and communication
Reframing the conversation from overhead to organizational effectiveness helps funders see the bigger picture. Strong administrative capacity ensures that programs are delivered efficiently, safely, and with measurable impact.
Some nonprofits create simple cost narratives or infographics in grant proposals to illustrate how indirect costs support program success. This can include case examples of how improved technology or financial controls have enabled better outcomes for service recipients.
Planning for Indirect Cost Recovery in Budget Development
When building program budgets, nonprofits should plan for indirect cost recovery from the start. This ensures that funding proposals are realistic and that the organization does not unintentionally underfund critical support services.
Key practices in budget planning include:
- Applying the current indirect cost rate to all grant budgets
- Including indirect costs in total funding requests
- Ensuring all direct and indirect cost classifications are accurate
- Reviewing each funder’s allowable cost policies before finalizing budgets
Early planning also allows finance teams to align grant deliverables with financial reporting systems, avoiding the need for last-minute reclassification or adjustments during the award period.
Avoiding Common Mistakes in Indirect Cost Recovery
Despite best intentions, many nonprofits fall into avoidable traps that reduce their ability to recover legitimate indirect costs. Some common errors include:
- Charging indirect expenses as direct costs to meet rate caps
- Using unrestricted donations to cover underreported overhead
- Failing to update the cost allocation plan as programs grow
- Applying outdated allocation bases that no longer reflect usage
- Ignoring unallowable costs in the indirect pool calculation
Avoiding these mistakes requires training, oversight, and a culture of financial accountability. Finance staff should work closely with program managers to ensure accurate tracking and classification of all costs.
Supporting Growth Through Strategic Overhead Investment
Overhead is often misunderstood as a liability. In reality, it is a strategic asset when managed wisely. Investments in systems, staff, and internal processes enable nonprofits to scale programs, improve outcomes, and enhance transparency.
Organizations that fund their infrastructure properly can:
- Reduce employee turnover through better HR systems
- Improve data accuracy with advanced technology.
- Strengthen relationships with funders through reliable reporting.
- Increase program efficiency by streamlining operations.
These benefits are only possible when nonprofits recognize the value of indirect costs and integrate overhead planning into their broader financial strategy.
Conclusion:
The ability to accurately calculate, negotiate, and recover indirect costs is essential for nonprofit sustainability. Organizations that build the right systems, adopt clear policies, and invest in strong financial management are better equipped to fulfill their mission over the long term.
While challenges remain—particularly in dealing with rate caps and complex funder requirements—nonprofits have more tools and guidance available than ever before. By embracing transparency, leveraging technology, and approaching indirect costs as a strategic priority, organizations can thrive in a competitive funding landscape.
