|Revision Date||November 1, 2011|
Cost allocation is a means of distributing funds to specific functions, activities, and/or programs the total costs associated with providing services to recipients. Cost allocation is required when the costs will benefit more than one contract, program, and/or funding source.
If cost allocation is necessary, contractors must:
- use a reasonable method of allocation approved by contract staff;
- demonstrate a reasonable reflection of the actual business operations; and
- be consistent in their use of allocation methods across all program areas and business entities in which the contractor has an interest
The purpose of cost allocation is to ensure:
- direct and indirect costs are properly and accurately recorded within each program area/funding source;
- each program receives its fair share of costs which benefit the respective program; and
- each program cost is properly identified.
A cost is allocable to a particular cost objective if it is treated consistently with other costs incurred for the same purpose in similar circumstances, and if it:
- is incurred specifically for the award;
- benefits both the award and other work and can be distributed in reasonable proportion to the benefits received; or
- is necessary to the overall operation of the organization, although a direct relationship to any particular cost objective cannot be shown.
Direct cost vs. indirect cost
A direct cost is one that is easily identifiable to a specific function, activity, or program. An indirect cost is one that is not easily identifiable, without effort, to a specific function, activity, or program and has been incurred for a common or joint objective. Both direct and indirect costs must be allocable to the program/contract.
Costs to provide services may be either direct or indirect. Once a cost is classified as a direct cost, it may not be reclassified as an indirect cost (and vice versa) for the specific program/funding source nor any other program/funding source. Therefore, in no circumstances can the exact same cost be considered both direct and indirect. In addition, both direct costs and indirect costs require a cost allocation methodology to ensure that each program/funding source receives its fair share of the total costs that benefit the program/funding source.
Direct costing is the charging of costs, whether direct or indirect, incurred for the benefit of or directly attributable to a specific business component, directly to that particular business component. For direct costs as defined in OMB UGG/Circular A-122 and OMB Circular A-87, direct costing is required. For indirect costs as defined in OMB UGG/Circulars A-122 and A-87, it is necessary to allocate these costs either directly or as a pool of costs across those business components sharing in the benefits of those costs. Direct costing must be used whenever reasonably possible.
Appropriate allocation of indirect costs
The indirect cost allocation method(s) to be used by each organization is dependent upon the organization's own structure, program functions, accounting system, and other factors. To ensure that indirect costs are properly allocated to a specific program, contract or funding source and so that each program's costs are properly identified, an indirect cost rate may be negotiated and established. (Refer to OMB Circulars/ UGG for the requirements for negotiating and establishing an indirect cost rate.)
An indirect cost rate is a mechanism for determining fairly and conveniently within the boundaries of sound administrative principles, what proportion of indirect costs should be charged to each program or funding source.
An approved indirect cost rate by the federal agency is one method of ensuring proper allocation of direct and indirect costs. However, the indirect cost proposal must be reviewed by DFPS staff to ensure that DFPS programs are receiving their fair share of costs. An indirect cost allocation method approved by some other department, program, or governmental entity is not automatically approved by DFPS.
Approved methods of cost allocation
If an indirect cost rate has not been negotiated and approved as described in OMB UGG/Circulars A-122 and A-87, a cost allocation method must be established.
The following are the basic methods that DFPS approves for allocation of shared (pooled) indirect costs:
1. Units-of-Service Cost Allocation
The units-of-service cost allocation method establishes ratios of units of service delivered by a specific program area to total units of service delivered by all program areas. The units-of-service method can only be used if all of the program areas delivered the same type of service (i.e., equivalent services) measured with the same unit of service (i.e., equivalent units). If all of the program areas (business components) do not have equivalent services measured in equivalent units, a cost-to-cost or functional allocation method would have to be used for shared indirect costs not directly chargeable to a specific program area or business component.
2. Cost-to-Cost Allocation
The cost-to-cost allocation method calculates the percentage of a specified cost base attributable to a specific program, contract or funding source and then uses this percentage to calculate that program's share of indirect costs. Administration costs are always allocated first to each program area, followed by the removal (or separate reporting) of any unallowable shared indirect costs for each program area for purposes of contracting with DFPS. This ensures that 100% (and only 100%) of the total shared indirect costs have been allocated across the various program areas.
These shared indirect costs must be allocated across all the program areas which benefit from these shared indirect costs. If there are some shared indirect costs that benefit only a portion of the corporation's program areas, then an allocation method must be used to properly allocate that subset of the total shared indirect costs to those program areas benefiting from those shared indirect costs.
3. Functional Cost Allocation
In some cases, costs may be more accurate and representative based upon a functional methodology rather than a units-of-service or cost-to-cost allocation method. The functional cost allocation method is a direct method of reporting shared administrative costs based on assigned duties or activities.
Functional cost allocation for an administrative staff person can be based upon a time study. Time studies can only be used to allocate administrative time and cannot be used to allocate direct care time. In other words, if an administrative employee also performs direct care duties, that employee must have time sheets (not a time study) to document his/her direct care time.
4. Tier Allocation Approach
In some instances, a combination of the three allocation methodologies may be required to ensure a more appropriate and equitable method of allocating particular shared costs. Shared indirect (administration) costs must be those benefiting all the entity's programs, contracts and/or funding sources. Therefore, if there are some indirect (administration) costs that benefit only a portion of the entity's program/contract areas, then an allocation method must be used to properly allocate that subset of administration costs. This subset allocation method is to ensure that only those program areas benefiting from the administration costs share in the costs, as opposed to all programs sharing the costs.
Compliance with DFPS Standards
If the contractor does not have an allocation plan or uses an allocation plan that does not meet the compliance guidelines, document this as an exception and request that the contractor develop, implement, and submit an allocation plan that complies with state and federal regulations. Indicate the amount of any questionable costs.