Full Cost Recovery: How to Price Your Real Costs

When Full Cost Recovery Matters

Full cost recovery means giving each contract or service a fair share of the organization's overheads, so that the project's funding pays for the overheads the project causes. Cost recovery in the wider sense is the set of ways a nonprofit makes sure every cost of implementing donor projects comes back to it.

Overheads get treated as fat, but they are the real costs of delivering a project well: finance, management, premises, training, insurance and IT.

The question bites when you write a budget, when you decide whether to bid, and when a funder offers a grant that pays less than the project truly costs. Funders differ here. Some cap indirect costs, some negotiate each grant, and some accept the figure the organization states. Many nonprofits end up recovering only what donors allow, because of power imbalances, weak budgeting practice and inertia. Their true costs are not lower. In a benchmarking study of 26 NGOs, central support costs averaged 11.42% (range 4% to 26%), while the indirect rate donors actually paid averaged 6.85%. Across those NGOs the unrecovered gap came to about 28 million pounds in a year, equal to about 3.1% of restricted income from those donors.

Underfunded overhead can, in the worst case, threaten an organization's survival and its ability to carry out its mission.

How It Works

Full cost recovery is a two-step process. First you account for all your costs. Then you allocate them within a framework that is consistent with prior years and transparent to the funder. In practice, getting from a ledger to a funder-ready budget line goes like this.

Classify every cost. Direct costs come from carrying out one specific activity. Indirect costs are shared organizational costs that are hard to pin on a single project. Indirect costs split further into central support (leadership, corporate finance, HR) and program support, such as senior managers overseeing programs, some technical advisors and country office functions. Program support is often not allowed as a direct cost.
Allocate the shared costs. Facilities, utilities and internet need an allocation basis that is reasonable, applied the same way every time, backed by current data and suited to the cost. Staff full-time equivalents suit costs driven by staff use, square footage suits occupancy, and headcount, time or expenditure also work. The choice matters less than having a logical, clearly stated cost driver. For people who split their time between program and administrative work, assign their pay in proportion to time, using a reasonable estimate such as a timesheet. If a cost cannot be allocated on a defensible basis, treat it as entirely indirect.
Work out the rate. Take a full year of expense data. The common formula is total indirect cost divided by total direct cost, as the indirect cost rate guide sets out.
Put a fair share in the project budget. Add the project's fair share of indirect costs as its own line, and you have the full cost of the project. The worked example below builds up the full cost of one project.
Show your basis to the funder. Hand over the workings along with the percentage. A rate on its own tells a funder little, because two organizations may classify similar costs differently.
Keep the records that let the rate survive a review. Use this checklist:
- Timesheets, or another reasonable time estimate, for every person who splits time between direct and indirect work.
- A written note of the allocation basis for each shared cost, and the data behind it.
- The full year of expense data the rate was calculated from.
- The classification behind the rate, so a funder can see what you counted as direct and what as indirect.

Key Components

A sound approach does not depend on one clever percentage. It depends on a few habits that hold up when someone checks your work.

A clear cost classification. Everyone in the organization should know what counts as direct, central support and program support. Program support aligns closely with program outcomes but is not charged to a specific project.
Consistent allocation bases. Pick a sensible driver for each shared cost, and then stick with it.
Time records. Use a timesheet or another reasonable estimate of time. Without one, the split of anyone's week is hard to defend.
A rule for what cannot be allocated. Deciding once that such costs go into the indirect pool saves arguments later.
A stated rate base. An organization that passes a lot of money to sub-grantees may find that a rate on total costs comes out too low. It can present a rate on another base, such as modified total direct costs, as long as it is open about it and uses it consistently.
One treatment per cost. A cost counted as indirect in the rate must not reappear as a direct line in a grant budget. The funder may be charged twice, or the rate left inadequate.

Best Practices

Know your true costs before you negotiate. Costing is what lets you decide whether to bid at all, and whether a shortfall is worth absorbing. Suppose your indirect need is 11.39% and a funder caps at 7%. You can decline, claim more of the costs as direct costs where they honestly belong to the project, or cover the gap from unrestricted funds when the work is worth it. Put numbers next to each choice before you answer the funder.

Present full workings. One organization budgeted its true indirect costs at about 15% and showed its calculations to a funder that had been paying 2% to 5%. It was funded at the full 15%. A funder can argue with a bare percentage. Workings are harder to wave away.

Use one allocation method from year to year. Funders trust a method that matches prior years and can be explained. Some accept only certain bases, so find out early which ones.

Build ownership beyond the finance team. Finance cannot change cost recovery alone. One large organization improved through cross-organizational buy-in, defined practices and measures, realistic targets, changes to policies and sign-off, and long-term monitoring. A self-assessment covering policy, systems, people, management culture and donor relationships helps, and so does approving each project with a clear view of its cost recovery and its likely surplus or deficit.

Cover your local partners' indirect costs, on flexible terms. When you pass money to local partners, their full direct and indirect costs must be covered, either by budgeting for them or by sharing the indirect funding you receive. Good practice is overhead that is unrestricted, not time-limited, not subject to individual project audit, and calculated on the partner's total budget. It should come on top of the administrative and project support costs charged directly, so that it strengthens the partner rather than plugging holes in a project budget. In one platform of Somali NGOs, the project received 8% indirect cost recovery and the fund manager passed on half, 4%, in proportion to budget, as unrestricted and unaudited funding. Local organizations working together in a consortium have also won equal splits of indirect costs from the lead international partner.

Common Mistakes

Accepting whatever the funder allows. It feels safe, but it locks in a gap you never measured. Compare the offer with your true rate first.

Costing on marginal cost only. Marginal costing funds only the extra cost of an activity and leaves out a share of overheads. Grow on that basis and the organization strains and its cost structure distorts. Cost the full share instead.

Treating one cost as both indirect and direct. Decide the classification once and apply it in the rate and in every budget.

Quoting a rate with no classification behind it. Different organizations classify similar costs differently, so a bare percentage compares badly. Send the classification along with the number.

Understating overhead to look efficient. Funders expect unrealistically low overhead, organizations feel pressure to conform, they underspend and underreport, and that reinforces the expectation. One organization found that administering a single grant cost about 31% of its value while the funder allowed 13% for indirect costs. Report what overhead really costs.

Ignoring which allocation bases a funder accepts. Your basis may be logical and still be refused. Ask early.

Example

Take a counseling project, costed in the organization's own currency units. The project's direct costs are 50,000 for activities. It also uses 25% of a 1,000 electricity bill, which is 250, and 50% of a 25,000 social worker salary, which is 12,500. Direct cost comes to 62,750.

Then the indirect side is added. Support costs are 31,500 and governance costs are 600. The full project cost is 94,850, about 51% above the direct cost. A funder that paid only the 62,750 would leave the organization to find the other 32,100 from unrestricted funds.