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.

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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
These 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

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sources of funding, projects, or programs.

Indirect Costs
These 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
These 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.

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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.

Cost allocation has traditionally been focused primarily on direct costs. But
many companies have considerable indirect expenses and lack transparency
into, and therefore control over, these indirect costs.

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.

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.

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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

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 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:

1. Identify and record all business activities within their department

for a given accounting period.
2. Categorize these activities as direct or indirect costs.
3. 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

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(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.

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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

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 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.

What’s your goal today?

1. Use PLANERGY to manage purchasing and accounts
payable
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management, process automation in purchasing and finance, and reducing
financial risks. To discover how we can help grow your business:

Read our case studies, client success stories, and testimonials.

Visit our “Solutions” page to see the areas of your business we can help
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Learn about us, and our long history of helping companies just like yours.

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2. Download our guide “Indirect Spend Guide”
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