How To Calculate Your Company’s Indirect Costs
Slicing and dicing spend to identify, calculate, and manage the various types of costs incurred by your organization in the course of doing business can be harrowing. And for many procurement organizations, most of the time and attention required to do so has traditionally been devoted to direct costs.
But it’s indirect costs—or rather, their management—that holds truly impressive promise for companies and organizations looking to improve their financial data tracking, analysis, and management. With the right methods and tools, companies who want to seize control over their indirect spend can allocate all those costs correctly and recover savings and build value.
Why Knowing How to Calculate Indirect Costs Matters
Most finance and procurement teams have little trouble identifying costs associated with direct procurement. Direct costs are straightforward and relatively simple: they’re the raw materials, components, direct labor costs, direct salaries, finished goods and professional services connected to the production of your company’s own products.
But indirect procurement is a horse of another color. Depending on the context, even seasoned pros might mistakenly treat terms such as indirect costs, shared costs, overhead costs, and administrative costs as synonyms. But the truth is, each of those terms have a contextual meaning that companies and organizations need to understand if they’re going to practice effective indirect spend management as part of their total spend management program.
Let’s take a look at some of the most important cost allocation terms:
Direct Costs can be connected to the production of your company’s goods or services. For schools and nonprofits, direct costs are those which can be specifically connected to a single program, project, or source of funding (both federal and non-federal).
Shared Direct Costs, also called common direct costs, are those specifically connected to either production, subcontractors, projects, departments, etc. For schools and nonprofits, this term refers to those direct costs connected directly to specific sources of funding, projects, or programs.
Indirect Costs are those with no direct association to a finished product or particular program or project. These costs are shared across the organization because they’re necessary to completing daily operations. Office supplies, capital expenditures, IT services, and salaries and insurance are all examples of indirect costs. They can be allocated individually, or calculated using one or more cost allocation methods involving an indirect cost rate (also called simply an indirect rate) and assigned to a single line item in the budget as “indirect expenses.”
Administrative Costs, while often assumed to be indirect costs, are actually a mix of direct and indirect costs, based on whether a specific expense can be tied to production or a specific program or project. For example, fringe benefits such as a company car or discount card may be considered a direct cost provided they can be justifiably allocated to production.
Overhead Costs are familiar to most procurement and financial professionals. Unlike nonprofits or schools, where the term generally refers to fundraising and, to a lesser extent, “the business of doing business,” for businesses the term hews almost exclusively to the latter definition. Rental costs, utilities, insurance, taxes, depreciation, salaries and wages…overhead costs aren’t directly tied to production, but they do pay for the support structures surrounding production.
Indirect spend management takes these factors into account and focuses on complete, transparent, and accurate allocation of expenses.
Obviously, a small business or corporation will take a different approach to calculating indirect costs. They answer to lenders, investors, and shareholders rather than funders and grant administrators, but companies still need reliable ways to identify, quantify, and then optimize their indirect costs in order to achieve optimal financial health. Effective indirect cost allocation and management can also help companies and organizations center procurement as a value creation center rather than a budget trimmer through:
- Greater spend transparency.
- More accurate financial reporting, budgeting and forecasting.
- Improved cash flow and strategic spend.
- Eliminating waste and inefficiency.
“They answer to lenders, investors, and shareholders rather than funders and grant administrators, but companies still need reliable ways to identify, quantify, and then optimize their indirect costs in order to achieve optimal financial health.”
How to Calculate Indirect Costs
Because their connection to production or a specific program or project isn’t always readily apparent, indirect costs can be more difficult to allocate correctly (and completely) than direct costs. And some expenses, like utilities, insurance, and wages simply can’t be neatly packaged up by percentages, with x% of a day’s wages supporting Project Y or z% of a day’s electricity powering the computers used for Production Line Q.
There’s no need to panic, however. The secret of effective indirect cost allocation lies in finding ways to treat indirect expenses as a single shared cost, and then finding ways to divide it up across projects, business units, production lines, etc. in a fair and proportionate way.
Some of the most common methods indirect cost calculation (IDC) include:
1. Fixed Cost Classification
The most basic of indirect cost allocation methods, fixed cost classification works best with (brace yourself) fixed expenses such as indirect labor costs, depreciation, and rent. These costs are recorded as charges to specific assets, projects, departments, subcontracts, business units, etc.
For example, wages for the marketing team are allocated to the marketing manager’s budget, office supplies are allocated to the department that ordered them (or, alternatively, to the business unit under whom multiple departments will share the supplies), and depreciation on a company copier is allocated to the copier itself.
2. Proportionate Allocation
“To each their own” is the principle underpinning proportionate allocation. Using this method, indirect costs are shared out among projects, departments, business units, etc. based on the type of cost and how the goods or services so purchased will be used. These percentages can be assigned monthly but are generally calculated, allocated, and reviewed once every fiscal year.
So, the company’s Internet services might be split evenly among the budgets of every department, whereas cleaning services might be allocated based on the square footage of a given department.
3. Activity-Based Cost Allocation
This approach to allocating your total indirect costs takes more time and effort, but is also much more accurate than proportionate or fixed cost allocation. To collect the data needed for indirect cost calculation, managers:
- Identify and record all business activities within their department for a given accounting period.
- Categorize these activities as direct or indirect costs.
- Analyze all costs and calculate indirect cost rates at the end of the accounting period (e.g. a month or a quarter), then allocate indirect costs accordingly.
Using Cost Rate Calculators
Indirect cost rate calculations rely on what’s known as a cost pool. This is a value representing total costs (in this case, total indirect costs) that are broken out and allocated based on percentages calculated in various ways, usually by dividing the cost pool by a cost object (i.e., a variable such as usage, generated revenue, physical dimensions, project category, department, etc.), also called a cost objective.
For example, if you’re using the proportionate allocation method, you could allocate your overhead costs by dividing your total overhead costs by the direct costs incurred by each specific department. The resulting indirect rate is called an overhead rate.
Let’s say your company’s total indirect costs are $600,000. 3D Printing (Production) has direct costs of $600,000, while engineering has $400,000 and design has $200,000, meaning your total direct costs are $1,200,000. Divide indirect costs to get an overhead rate of 50%:
600,000 ÷ 1,200,000 = .5
Now, calculate each department’s share of the total indirect costs by multiplying each department’s total direct costs by the overhead rate.
- 3D Printing: $600,000 x .5 = $300,000
- Engineering: $400,0000 x .5 = $200,000
- Design: $200,000 x .5 = $100,000
- Total indirect costs: $600,000
Breaking out expenses this way is very similar to a method used to allocate direct and indirect expenses by project rather than department, using what’s known as a Total Project Cost (TPC) calculation.
This cost allocation method multiplies the overhead rate for a specific department, source of funding, or project by a total direct cost base. This value is either your total direct costs (TDC) for the department, project, etc. or another value known as Modified Total Direct Costs (MTDC), which is all direct costs minus budget items that don’t carry overhead.
The MTDC base method is commonly used by schools and nonprofits who receive funds from a federal agency or the federal government itself (and also by those who receive funding from non-federal sources, albeit less commonly).
Nonprofits and schools generally have specific indirect rate agreements in place with sponsors and funding sources. However, applying indirect rates to a MTDC base is also useful for businesses who want to budget by project, subcontractor, or other cost objectives for a more granular breakdown of indirect cost allocation.
Targeting Indirect Costs for Greater Savings and Value
Cost allocation has traditionally been focused primarily on direct costs. But many companies have considerable indirect expenses (often between 25 and 40 percent) and lack transparency into, and therefore control over, these indirect costs.
As a result, those same companies have significant opportunity to capture increased savings and build value through process optimization and a shift in focus toward monitoring and streamlining their total spend, rather than prioritizing direct spend management alone.
One of the most effective ways to simplify and streamline tracking, calculating, and allocating indirect costs correctly is with the use of eProcurement software like PLANERGY.
With cloud-based, centralized data management, process automation, and advanced analytic tools, you can:
- Categorize and capture all spend data—including indirect spend—and access it for review and analysis in real time.
- Create and modify cost pools as needed to generate accurate reports, budgets, and forecasts, as well as actionable insights.
- Use category management, contract management, and supplier relationship management tools to create guided buying environments.
- Eliminate both maverick spend and invoice fraud, which can wreak havoc on financial reporting and forecasting and hamper cash flow management.
- Leverage insights provided through spend analysis to refine your supply chain to ensure strategic and cost-effective indirect spend across all projects, departments, business units, etc.
Calculate and Streamline Indirect Costs
Knowing what you’ve spent, who got the money, and how it’s supporting your business makes it much easier to plan ahead and make smarter strategic, spending, and development decisions. By calculating and allocating your indirect spend correctly, you can improve your spend visibility, reduce waste and needless expenses, and ensure every part of your organization is doing its part to support your company’s goals for productivity and profitability.
Gain full visibility into, and detailed control over, your indirect spend with PLANERGY