Was your rate structure used to allocate indirect costs to your products or services established to satisfy your accounting software? Was it dictated by your customer? Did you set it up because you thought that is what was needed to win contracts? Did you get it from a book or seminar, or even Google? If you answered “yes” to any of these questions, you need to read further.
One of the least appreciated and most maligned tools in management’s toolbox is the indirect expense or overhead rate allocation. The indirect expense allocation of an organization, whether for-profit or not-for-profit, whether service-oriented or a manufacturer, whether private or public or some combination of them all should mirror the operational organization. One size does not fit all!
For these reasons the allocation of indirect expenses should be considered both a strategic and a tactical element of your business plan. It is more than just a by-product of the accounting and budgeting system. Your indirect expense allocation plan must play a major role in supporting your strategic business model and must not be inconsistent with your businesses operating model.
Indirect expense allocation plans are influenced by many factors and must reflect as accurately as possible the most
- efficient operating structure of the organization,
- competitive allocation of costs to the organizations final cost objectives,
- realistic projections of the anticipated future direction of the organization,
- proper identification of the “true” cost of an organizations final cost objectives,
- meaningful information upon which management can base its decision making process, and
- favorable cost recovery and cash flow scenario.
An indirect expense allocation plan should accomplish two things:
- facilitate management’s decision making process, and
- identify opportunities to maximize cost recovery.
Indirect expenses including fringe costs, overhead costs and general and administrative expenses can represent well over two-thirds of an organization’s product or service cost. Management needs to know what something truly costs before they can make an educated decision regarding how it should be handled. Do you want to continue delivering a particular line of service or product? Are you making money on it? What does it cost you? These are all questions requiring a good indirect cost allocation plan and cost allocation system.
Cost recovery is the second reason for having a good indirect cost allocation plan. You need to make sure you are pricing all your allowable/recoverable costs into your products or services. Are you billing all of the costs incurred? Are you allocating them to the right products or services where they can best be recovered?
Considerations when developing an indirect cost allocation plan:
Developing a good indirect cost allocation plan that is dynamic and that accurately reflects the strategic and tactical goals of the organization requires addressing many structural alternatives such as but not necessarily limited to:
- Determining what functions are to be identified as direct costs and those that are to be identified as allocable indirect costs
- Determining the basis for indirect cost allocation
- Deciding whether the indirect cost structure should be complex (e.g., multiple expense pools and allocation bases) or simple (e.g., single expense pools and single allocation bases). Single rate pools are more easily understood, more consistent over time but tend to smear costs across products or services in what is referred to as the “peanut butter effect”
- Determining the most equitable allocation process for “service centers” e.g., reproduction, graphics, information technology, facilities, communication services, etc.) to interim or final cost objectives
Other considerations center on auditability and flexibility. The more complex the indirect rate allocation plan, the harder it is to understand and therefore to audit. The more complex structures are also more sensitive to changes in the business structure, the adding or deletion of operational centers and the changes in product or service composition. Simplified structures can accept changes with minimal impacts on the overall rates and are easily understood for auditing purposes. The trade off? Simplified indirect cost allocation plans might not provide accurate product or services costing.
A final distinction must be made between the cost of a product or service and its price. Cost is the appropriate allocation and accumulation of actual or estimated costs against a final cost objective. Price is a management decision reflecting an anticipated return on investment (e.g., profit). Price may be determined based on cost and it may not. It’s a decision management has to make knowing the actual “true” cost of the given product or service.
Cost allocation plans should be developed for both government contractors and not-for-profit organizations in compliance with the requirements of the Federal Acquisition Regulations and applicable Office of Management and Budget (OMB) Circulars.