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CPE for Government Auditors

Composition of Costs

Please enjoy Chapter 3  on Composition of Costs from the self-study book entitled “New Uniform Guidance: Cost Principles for Non-Profits and Governments” by Sefton Boyars and Bill Allen available on YellowBook-CPE http://yellowbook-cpe.com/product/cost-principles

Objectives:

  • Distinguish between an indirect cost and a direct cost

The total cost of federal awards consists of the allowable direct costs of the program, plus its allocable portion of allowable indirect costs, less any applicable credits.

The regulations specifically state that there is no rule for deciding which costs are direct and which are indirect.  They permit the classification of minor items of direct costs to be treated as indirect so long as the classification is consistent.  Treating like costs consistently in like circumstances, as either direct or indirect, cannot be overemphasized.  When costs are treated inconsistently, cost disallowances will frequently occur.  Overall, inconsistent costing may have resulted in more dollars of audit findings than any other reason.

With regard to the total composition of cost and the allocation of costs to a particular award, 2 CFR 200 provides:

§200.402 Composition of costs.

Total cost. The total cost of a Federal award is the sum of the allowable direct and allocable indirect costs less any applicable credits.

§200.405 Allocable costs.

(a)    A cost is allocable to a particular Federal award or other cost objective if the goods or services involved are chargeable or assignable to that Federal award or cost objective in accordance with relative benefits received. This standard is met if the cost:
(1) Is incurred specifically for the Federal award;
(2) Benefits both the Federal award and other work of the non-Federal entity and can be distributed in proportions that may be approximated using reasonable methods; and
(3) Is necessary to the overall operation of the non-Federal entity and is assignable in part to the Federal award in accordance with the principles in this subpart.

(b)    All activities which benefit from the non-Federal entity’s indirect (F&A) cost, including unallowable activities and donated services by the non-Federal entity or third parties, will receive an appropriate allocation of indirect costs.
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(d) Direct cost allocation principles.  If a cost benefits two or more projects or activities in proportions that can be determined without undue effort or cost, the cost should be allocated to the projects based on the proportional benefit.  If a cost benefits two or more projects or activities in proportions that cannot be determined because of the interrelationship of the work involved, then, notwithstanding paragraph (c) of this section, the costs may be allocated or transferred to benefitted projects on any reasonable documented basis. …
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2 CFR 200 discusses the classification of costs as either direct costs or indirect costs.  Although the CFR provides a discussion of both types of cost, we have to go to the Definitions in Subpart A to find the less complicated definition of indirect costs.  Both are described in brief below:

Direct and Indirect (F&A) Costs

§200.412 Classification of costs.

There is no universal rule for classifying certain costs as either direct or indirect (F&A) under every accounting system. A cost may be direct with respect to some specific service or function, but indirect with respect to the Federal award or other final cost objective. Therefore, it is essential that each item of cost incurred for the same purpose be treated consistently in like circumstances either as a direct or an indirect (F&A) cost in order to avoid possible double-charging of Federal awards. …

§200.413 Direct costs.

(a)     General.  Direct costs are those costs that can be identified specifically with a particular final cost objective, such as a Federal award, or other internally or externally funded activity, or that can be directly assigned to such activities relatively easily with a high degree of accuracy. Costs incurred for the same purpose in like circumstances must be treated consistently as either direct or indirect (F&A) costs.

§200.56 Indirect (facilities & administrative (F&A)) costs 1. 

Indirect (F&A) costs means those costs incurred for a common or joint purpose benefitting more than one cost objective, and not readily assignable to the cost objectives specifically benefitted, without effort disproportionate to the results achieved. To facilitate equitable distribution of indirect expenses to the cost objectives served, it may be necessary to establish a number of pools of indirect (F&A) costs. Indirect (F&A) cost pools should be distributed to benefitted cost objectives on bases that will produce an equitable result in consideration of relative benefits derived.

For instance, if the school district charges the federal grantor for janitorial labor as a direct cost one quarter and as an indirect cost the next quarter, it will appear to the grantor and the auditor as though one of the following has occurred:

•    The grantee is not keeping good records,
•    The grantee is not conscious of the difference between direct and indirect costs, or
•    The grantee is trying to take advantage of the grantor by moving amounts between categories.

At the start, the grantee should make a clear, conscious decision about how to charge items.  Not only should this decision be followed consistently, but also it should be well documented. Even if the auditor and the grantor later disagree with your choice, they will at least be comforted knowing that you are making an effort to be a good steward with the federal monies.

3-1  Direct Costs

Direct costs are those costs that can be identified specifically with a particular final cost objective, i.e. a particular award, project, service, or other direct activity of an organization.  This could involve a specific, federally-funded project or a non-Federal project or activity that will be treated as the equivalent of a federal project.

Examples of direct costs often charged to federal awards are:

•    Salary and Wages – Amounts paid to employees for the time they spend specifically working on the grant project.
•    Supplies – Amounts paid for resources that are purchased or used for the grant project.
•    Equipment – Amounts paid for any equipment and other qualifying capital expenditures.
•    Travel – Amounts paid for traveling so long as they are incurred for grant purposes.

§200.413 Direct costs.

(a)     General.  Direct costs are those costs that can be identified specifically with a particular final cost objective, such as a Federal award, or other internally or externally funded activity, or that can be directly assigned to such activities relatively easily with a high degree of accuracy. Costs incurred for the same purpose in like circumstances must be treated consistently as either direct or indirect (F&A) costs.  See also §200.405 Allocable costs.

(b) Application to Federal awards.  Identification with the Federal award rather than the nature of the goods and services involved is the determining factor in distinguishing direct from indirect (F&A) costs of Federal awards.  Typical costs charged directly to a Federal award are the compensation of employees who work on that award, their related fringe benefit costs, the costs of materials and other items of expense incurred for the Federal award.  If directly related to a specific award, certain costs that otherwise would be treated as indirect costs may also include extraordinary utility consumption, the cost of materials supplied from stock or services rendered by specialized facilities or other institutional service operations.

(c) The salaries of administrative and clerical staff should normally be treated as indirect (F&A) costs.  Direct charging of these costs may be appropriate only if all of the following conditions are met:
(1) Administrative or clerical services are integral to a project or activity;
(2) Individuals involved can be specifically identified with the project or activity;
(3) Such costs are explicitly included in the budget or have the prior written approval of the Federal awarding agency; and
(4) The costs are not also recovered as indirect costs.

(d) Minor items. Any direct cost of minor amount may be treated as an indirect (F&A) cost for reasons of practicality where such accounting treatment for that item of cost is consistently applied to all Federal and non-Federal cost objectives.

(e) The costs of certain activities are not allowable as charges to Federal awards. However, even though these costs are unallowable for purposes of computing charges to Federal awards, they nonetheless must be treated as direct costs for purposes of determining indirect (F&A) cost rates and be allocated their equitable share of the non-Federal entity’s indirect costs if they represent activities which:
(1) Include the salaries of personnel,
(2) Occupy space, and
(3) Benefit from the non-Federal entity’s indirect (F&A) costs.

(f) For nonprofit organizations, the costs of activities performed by the non-Federal entity primarily as a service to members, clients, or the general public when significant and necessary to the non-Federal entity’s mission must be treated as direct costs whether or not allowable, and be allocated an equitable share of indirect (F&A) costs. Some examples of these types of activities include:
(1) Maintenance of membership rolls, subscriptions, publications, and related functions.  See also §200.454 Memberships, subscriptions, and professional activity costs.
(2) Providing services and information to members, legislative or administrative bodies, or the public.  See also §§200.454 Memberships, subscriptions, and professional activity costs and 200.450 Lobbying.
(3) Promotion, lobbying, and other forms of public relations.  See also §§200.421 Advertising and public relations and 200.450 Lobbying.
(4) Conferences except those held to conduct the general administration of the non-Federal entity. See also §200.432 Conferences.
(5) Maintenance, protection, and investment of special funds not used in operation of the non-Federal entity.
(6) Administration of group benefits on behalf of members or clients, including life and hospital insurance, annuity or retirement plans, and financial aid.  See also §200.431 Compensation—fringe benefits.

For instance, the salary of the organization’s project director incurred in the performance of his duties as the award team leader for a specific award would likely be considered a direct cost.  However, we always need to consider the general rules of allowability, particularly the rules regarding consistency.

3-2  Indirect Costs

Indirect costs are those incurred for a common or joint purpose benefiting more than one cost objective.  They cannot be readily assigned to a final cost objective without an effort that is disproportionate to the results achieved 2.  In other words, they drive accountants crazy.

As mentioned previously, the cost principles allow grantees to treat any direct cost of a minor amount as an indirect cost for reasons of practicality, provided that the item of cost is treated consistently for all cost objectives.  Once again, the cost principles emphasize the issue of consistency.

§200.413 Direct costs.

(d) Minor items. Any direct cost of minor amount may be treated as an indirect (F&A) cost for reasons of practicality where such accounting treatment for that item of cost is consistently applied to all Federal and non-Federal cost objectives.

§200.405 Allocable costs.

(a) A cost is allocable to a particular Federal award or other cost objective if the goods or services involved are chargeable or assignable to that Federal award or cost objective in accordance with relative benefits received. This standard is met if the cost:
(1) Is incurred specifically for the Federal award;
(2) Benefits both the Federal award and other work of the non-Federal entity and can be distributed in proportions that may be approximated using reasonable methods; and
(3) Is necessary to the overall operation of the non-Federal entity and is assignable in part to the Federal award in accordance with the principles in this subpart.

(b)     All activities which benefit from the non-Federal entity’s indirect (F&A) cost, including unallowable activities and donated services by the non-Federal entity or third parties, will receive an appropriate allocation of indirect costs.
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(d) Direct cost allocation principles.  If a cost benefits two or more projects or activities in proportions that can be determined without undue effort or cost, the cost should be allocated to the projects based on the proportional benefit.  If a cost benefits two or more projects or activities in proportions that cannot be determined because of the interrelationship of the work involved, then, notwithstanding paragraph (c) of this section, the costs may be allocated or transferred to benefitted projects on any reasonable documented basis.

§200.414 Indirect (F&A) costs.

(a) Facilities and Administration Classification.  For major IHEs and major nonprofit organizations, indirect (F&A) costs must be classified within two broad categories: “Facilities” and “Administration.” “Facilities” is defined as depreciation on buildings, equipment and capital improvement, interest on debt associated with certain buildings, equipment and capital improvements, and operations and maintenance expenses. Administration” is defined as general administration and general expenses such as the director’s office, accounting, personnel and all other types of expenditures not listed specifically under one of the subcategories of “Facilities” (including cross allocations from other pools, where applicable). For nonprofit organizations, library expenses are included in the “Administration” category; for institutions of higher education, they are included in the “Facilities” category.  Major IHEs are defined as those required to use the Standard Format for Submission as noted in Appendix III to Part 200 – Indirect (F&A) Costs Identification and Assignment, and Rate Determination for Institutions of Higher Education (IHEs) paragraph C. 11.  Major nonprofit organizations are those which receive more than $10 million dollars in direct Federal funding.

(b) Diversity of nonprofit organizations.  Because of the diverse characteristics and accounting practices of nonprofit organizations, it is not possible to specify the types of cost which may be classified as indirect (F&A) cost in all situations.  Identification with a Federal award rather than the nature of the goods and services involved is the determining factor in distinguishing direct from indirect (F&A) costs of Federal awards.  However, typical examples of indirect (F&A) cost for many nonprofit organizations may include depreciation on buildings and equipment, the costs of operating and maintaining facilities, and general administration and general expenses, such as the salaries and expenses of executive officers, personnel administration, and accounting.
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3-2-1  Indirect Cost Allocation Plans

The allocations of indirect costs to benefiting departments within the organization can range from being relatively simple to being painfully complex.  Accounting is supposed to reflect reality, so:

•    With a large and varied organization, such as a general governmental, the indirect cost allocation will likely require a complex plan to appropriately distribute the indirect costs to users of the various services that such organizations typically provide.

•    With a relatively simple organization, such as many nonprofits, the indirect cost allocation plan will likely be correspondingly easy to develop and administer.

New to the uniform cost standards is a provision permitting some awardees to charge indirect costs at a rate of ten percent of modified total direct costs (MTDC) 3.  Section 200.414, paragraph (f) provides the following regarding this new feature included in the cost standards:

•    A non-Federal entity that has never received a negotiated indirect cost rate, with certain exceptions, may elect to charge a de minimis rate of 10 percent of MTDC;

•     The rate may be used indefinitely;

•    As always in the cost standards, for costs to be allowable, the costs must be consistently charged as either indirect or direct costs but may not be double-charged or inconsistently charged as both; and

•    Once elected, this methodology must be used consistently for all Federal awards until such time as a non-Federal entity chooses to negotiate for a rate, which the non-Federal entity may apply to do at any time.

As always, in developing any cost allocation plan, it is crucial to be consistent in both the assignment of costs and the use of equitable methods to distribute those costs to all cost objectives 4.

§200.414 Indirect (F&A) costs.

(c)    Federal Agency Acceptance of Negotiated Indirect Cost Rates. (See also §200.306 Cost sharing or matching.)
(1) The negotiated rates must be accepted by all Federal awarding agencies.  A Federal awarding agency may use a rate different from the negotiated rate for a class of Federal awards or a single Federal award only when required by Federal statute or regulation, or when approved by a Federal awarding agency head or delegate based on documented justification…
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(e) Requirements for development and submission of indirect (F&A) cost rate proposals and cost allocation plans are contained in Appendices III-VII as follows:
(1) Appendix III to Part 200 — Indirect (F&A) Costs Identification and Assignment, and Rate Determination for
(2) Appendix IV to Part 200 — Indirect (F&A) Costs Identification and Assignment, and Rate Determination for Nonprofit Organizations;
(3) Appendix V to Part 200 — State/Local Government and Indian Tribe-Wide Central Service Cost Allocation Plans;
(4) Appendix VI to Part 200 — Public Assistance Cost Allocation Plans; and
(5) Appendix VII to Part 200 — States and Local Government and Indian Tribe Indirect Cost Proposals.

(f)    In addition to the procedures outlined in the appendices in paragraph (e) of this section, any non-Federal entity that has never received a negotiated indirect cost rate, except for those non-Federal entities described in Appendix VII to Part 200—States and Local Government and Indian Tribe Indirect Cost Proposals, paragraph (d)(1)(B) may elect to charge a de minimis rate of) 10% of modified total direct costs (MTDC) which may be used indefinitely.   As described in §200.403 Factors affecting allowability of costs, costs must be consistently charged as either indirect or direct costs, but may not be double charged or inconsistently charged as both.  If chosen, this methodology once elected must be used consistently for all Federal awards until such time as a non-Federal entity chooses to negotiate for a rate, which the non-Federal entity may apply to do at any time.
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3-2-2  Charges from Internal Service Funds

Many larger organizations have internal service funds that can account for activities that act as small businesses within the entity such as copy centers, motor pools, IT services, etc.

The cost of services provided by such facilities operated by governmental units and nonprofit organizations are allowable provided that the charges for the services conform to federal cost principles.

Accordingly, they must consider any items of income or federal financing that qualify as applicable credits.

•    2 CFR, §200.416 refers to the costs of these internal organizations, when part of government (including Indian Tribal governments), as “central service costs.”
•    2 CFR, §200.468 refers to the costs of these internal organizations for all other organizations as “specialized service facilities.”

2 CFR §200.417 Interagency service allows a standard indirect cost rate of 10% of direct salaries if the organization chooses not to develop the actual indirect costs applicable to the center. For every dollar of salary of employees of an internal service agency is charged to a grant, the agency can charge an extra ten cents in indirect costs.  This is a very low indirect cost reimbursement rate. It may well be worth it for the grantee to justify a higher rate through study and documentation of indirect costs.

The costs of these internal services, when material, must be charged directly to applicable awards based on actual usage, using a method that is equitable to both federally-sponsored and other users and recovers only the aggregate costs of the services.

Special Considerations for States, Local Governments and Indian Tribes

§200.416 Cost allocation plans and indirect cost proposals.

(a) For states, local governments and Indian tribes, certain services, such as motor pools, computer centers, purchasing, accounting, etc., are provided to operating agencies on a centralized basis.  Since Federal awards are performed within the individual operating agencies, there needs to be a process whereby these central service costs can be identified and assigned to benefitted activities on a reasonable and consistent basis.  The central service cost allocation plan provides that process.

(b)     Individual operating agencies (governmental department or agency), normally charge Federal awards for indirect costs through an indirect cost rate. A separate indirect cost rate(s) proposal for each operating agency is usually necessary to claim indirect costs under Federal awards.  Indirect costs include:
(1) The indirect costs originating in each department or agency of the governmental unit carrying out Federal awards and
(2) The costs of central governmental services distributed through the central service cost allocation plan and not otherwise treated as direct costs.

(c)     The requirements for development and submission of cost allocation plans (for central service costs and public assistance programs) and indirect cost rate proposals are contained in Appendices IV, V and VI to this part.

§200.417 Interagency service.

The cost of services provided by one agency to another within the governmental unit may include allowable direct costs of the service plus a pro-rated share of indirect costs.  A standard indirect cost allowance equal to ten percent of the direct salary and wage cost of providing the service (excluding overtime, shift premiums, and fringe benefits) may be used in lieu of determining the actual indirect costs of the service.  These services do not include centralized services included in central service cost allocation plans as described in Appendix V to Part 200—State/Local Government and Indian Tribe Wide Central Service Cost Allocation Plans.

As noted above, 2 CFR, §200.468 refers to the costs of these internal organizations for all other organizations as “specialized service facilities.”

§200.468 Specialized service facilities. 

(a) The costs of services provided by highly complex or specialized facilities operated by the non-Federal entity, such as computing facilities, wind tunnels, and reactors are allowable, provided the charges for the services meet the conditions of either paragraphs (b) or (c) of this section, and, in addition, take into account any items of income or Federal financing that qualify as applicable credits under §200.406 Applicable credits.

(b)    The costs of such services, when material, must be charged directly to applicable awards based on actual usage of the services on the basis of a schedule of rates or established methodology that:
(1) Does not discriminate between activities under Federal awards and other activities of the non-Federal entity, including usage by the non-Federal entity for internal purposes, and
(2) Is designed to recover only the aggregate costs of the services. The costs of each service must consist normally of both its direct costs and its allocable share of all indirect (F&A) costs. Rates must be adjusted at least biennially, and must take into consideration over/under applied costs of the previous period(s).

(c) Where the costs incurred for a service are not material, they may be allocated as indirect (F&A) costs.

(d) Under some extraordinary circumstances, where it is in the best interest of the Federal government and the non-Federal entity to establish alternative costing arrangements, such arrangements may be worked out with the Federal cognizant agency for indirect costs.

Most large cities have a motor pool and repair shop.  Instead of receiving an “appropriation” or monies with which to operate, they fund their activities by charging the departments a fee for using and/or fixing vehicles.  In this way, they act like a business. Although they should not make a profit, they do draw off the budgets of the other departments in order to pay for their expenses.

To the police chief who must pay $70 to get the oil changed on his patrol cars, the motor pool might seem like a rip-off.  But, considering the amount it would cost the department for one of his officers to take an hour or two from policing to drive to Jiffy Lube and sit in the patrol car while it is serviced, as well as the training it would require for the officers know what to request at Jiffy Lube, etc., the charge might not be too bad.  The costs of services normally include both its direct costs and its allocable share of all indirect costs.

Chapter 3 Summary

The total cost of federal awards consists of the allowable direct costs of the program, plus its allocable portion of allowable indirect costs, less any applicable credits.  There is no universal rule for classifying certain costs as either direct or indirect.

Direct costs are those costs that can be readily and specifically identified with a particular final cost objective, i.e. a particular award, project, service, or other direct activity of an organization.  For example, the salary of the project director is most likely a direct cost to the federal award.

Indirect costs are those costs incurred by the grantee organization for a common or joint purpose benefiting more than the specific federal award and not readily assignable to any specific project without undue difficulty.  The cost principles permit minor items of direct costs to be treated as indirect provided that such costs are classified consistently.

Assuming the costs are otherwise allowable, indirect costs include costs passed through the organizations by other departments and divisions for supplying goods, services, and facilities (internal service funds).

There is no rule for deciding which costs are direct and which are indirect.  Therefore, treating costs consistently in like circumstances, as either direct or indirect costs, is a must.

 

1  The less complicated definition of indirect costs is found in 2 CFR 200, Subpart A.  The description of indirect costs becomes more complicated in §200.414 Indirect (facilities & administrative (F&A)) costs.
2  Organizations may need an indirect cost allocation plan to properly distribute common costs to all benefiting activities.
3  §200.68 Modified Total Direct Cost (MTDC).  MTDC means all direct salaries and wages, applicable fringe benefits, materials and supplies, services, travel, and subawards and subcontracts up to the first $25,000 of each subaward or subcontract. MTDC excludes equipment, capital expenditures, charges for patient care, rental costs, tuition remission, scholarships and fellowships, participant support costs and the portion of each subaward and subcontract in excess of $25,000.
4  This course is not intended to delve into indirect cost allocations.  For the masochists among you, courses in indirect costs are available.

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