What are indirect costs?
Every organization has two types of costs: direct costs and indirect costs. Direct costs are unambiguously tied to a specific project, product, or contract — a programmer's salary on a software project, the raw materials in a manufactured product, or the travel costs for a specific client engagement.
Indirect costs (also called overhead or burden) are costs that benefit multiple projects or the organization as a whole but cannot be directly assigned to a single cost objective. Examples include office rent, utility bills, administrative salaries, accounting and legal fees, insurance, and general software subscriptions.
Because indirect costs exist but cannot be billed directly to any single project, organizations use an indirect cost rate to allocate a fair share of these costs to each project or contract. The rate answers the question: for every dollar (or hour) of direct cost, how much indirect cost should also be assigned?
Calculating indirect costs correctly matters for several reasons:
- Project pricing. Without accurate indirect cost allocation, you may underprice projects and lose money even when direct costs are covered.
- Grant and contract compliance. Government grants (federal, state) and contracts require documented indirect cost rates. Using an incorrect rate can trigger audit findings or cost disallowances.
- Internal cost visibility. Tracking indirect costs by department or program reveals which activities are consuming disproportionate overhead resources.
- Financial reporting accuracy. Properly allocated indirect costs produce accurate project-level P&L rather than distorted gross margins.
Indirect cost rate formula
Then to assign indirect cost to a specific project:
Project Indirect Cost = Project Direct Cost × Indirect Cost Rate
And total project cost:
Total Project Cost = Direct Cost + Indirect Cost
How the numbers flow — project cost waterfall
The waterfall below shows how indirect cost is layered onto direct project costs to arrive at total project cost, using the service firm example ($50,000 direct, 40% indirect rate):
What is an indirect cost pool?
The pool is the numerator — the total dollar amount of indirect costs accumulated for a period (usually a fiscal year). To build the pool, list all costs that cannot be directly attributed to a single project or product:
- Rent and utilities for shared office or facility space
- Salaries of administrative, HR, accounting, and IT staff
- Depreciation on shared equipment and buildings
- General insurance, legal fees, and audit costs
- Fringe benefits tied to indirect employees
- Office supplies, postage, and general subscriptions
Choosing the right allocation base
The allocation base is the denominator — the measure used to distribute indirect costs fairly across projects. The base should reflect the primary driver of indirect cost consumption. A poor choice of base can systematically over-charge some projects and under-charge others.
| Allocation base | Rate type | Best for | Example |
|---|---|---|---|
| Direct Labor Cost ($) | % of labor $ | Service firms, professional services, consulting — where labor drives overhead | Pool $80k ÷ Labor $200k = 40% |
| Direct Labor Hours | $ per hour | Manufacturing, engineering — overhead tied to machine or labor time | Pool $120k ÷ 4,000h = $30/hr |
| Direct Materials ($) | % of material $ | Material-intensive manufacturing where materials drive facility usage | Pool $60k ÷ Materials $300k = 20% |
| Total Direct Cost (TDC) | % of all direct $ | Nonprofits, grant-funded projects, G&A allocation — simple all-in base | Pool $300k ÷ TDC $1M = 30% |
| Modified Total Direct Cost (MTDC) | % of MTDC $ | Federal grants & contracts — excludes equipment, subcontracts >$25k, tuition | Pool $45k ÷ MTDC $150k = 30% |
The most commonly used base in service industries and government contracting is direct labor cost, because labor drives most overhead consumption in those contexts. For manufacturing, direct labor hours or machine hours are preferred. Choose the base that most equitably reflects how projects actually consume your indirect resources.
MTDC — Modified Total Direct Cost (for grants)
Federal grants under 2 CFR Part 200 (Uniform Guidance) require using MTDC as the base for indirect cost rates. MTDC starts with total direct costs but excludes the following:
Equipment and capital expenditures · Subcontract amounts exceeding $25,000 per subcontract · Patient care costs · Tuition remission · Rental costs for off-site facilities · Scholarships and fellowships
Using TDC instead of MTDC for a federal grant would overstate the base, resulting in an artificially lower indirect rate and under-recovering overhead costs. Always confirm which base your funder requires before calculating your rate.
How to calculate indirect cost — step by step
Overhead rate vs G&A rate vs fringe rate — what's the difference?
"Indirect cost rate" is an umbrella term. Most organizations with significant overhead use multiple pools and multiple rates, each serving a different purpose. Confusing these three is one of the most common mistakes in cost accounting.
Covers indirect costs of production or service delivery departments — facilities, supervision, shop supplies, equipment depreciation tied to producing work.
General and Administrative — costs of running the organization as a whole: executive salaries, accounting, HR, legal, finance. Applied after overhead.
Employee benefit costs — vacation, sick leave, health insurance, payroll taxes, retirement contributions. Applied to direct and indirect labor costs.
In government contracting (DCAA, FAR compliance), these three rates are typically structured in a specific sequence: fringe rate is applied to all salaries first, overhead rate is applied to direct labor (with fringe), and G&A is applied to the total cost input last. For smaller organizations and basic project costing, a single blended indirect rate is simpler and usually sufficient.
Worked examples
These four examples match the preset values in the Indirect Cost Calculator.
40% rate on direct labor
Pool $80,000 overhead ÷ $200,000 direct labor base
Project direct labor = $50,000
Indirect = $50,000 × 40% = $20,000
Total project cost = $70,000
✓ Most common base for professional service firms
30% rate on MTDC base
Pool $45,000 ÷ MTDC $150,000 (TDC $180k minus $30k equipment)
Project MTDC base = $30,000
Indirect = $30,000 × 30% = $9,000
Total project cost = $39,000
→ Use MTDC base for federal grants (2 CFR 200)
$30/hr rate on labor hours
Pool $120,000 ÷ 4,000 direct labor hours = $30 per hour
Project hours = 500
Indirect = 500h × $30 = $15,000
Total project cost = direct + $15,000
→ Hour-based rate works when labor time varies widely
30% G&A on total direct cost
G&A pool $300,000 ÷ total direct cost base $1,000,000
Project direct cost = $80,000
G&A = $80,000 × 30% = $24,000
Total project cost = $104,000
⚠ G&A applied after overhead — sequence matters
Common mistakes when calculating indirect costs
- Including direct costs in the indirect pool. Costs that can be specifically identified with a project must be classified as direct and billed directly. Putting them in the indirect pool and then reallocating them across all projects causes cross-subsidization — some projects pay for costs they did not incur.
- Using TDC instead of MTDC for federal grants. The Uniform Guidance (2 CFR 200) requires MTDC as the base for federal awards. Using TDC (which includes equipment and large subcontracts) overstates the base, understates the rate, and under-recovers indirect costs — leaving the organization funding overhead from unrestricted reserves.
- Choosing an allocation base that doesn't reflect cost drivers. If your overhead is primarily rent and utilities (space-driven), using direct labor hours as the base may be appropriate. But if overhead is mostly IT and software (user-driven), headcount or direct labor cost may be more equitable. A mismatched base systematically over-charges labor-intensive projects.
- Setting the rate once and never updating it. Indirect costs change as the organization grows, shrinks, or shifts activities. Using a three-year-old rate can significantly over- or under-charge projects. Review rates at least annually and reconcile actual costs against applied rates.
- Confusing the indirect cost rate with the indirect cost percentage of total cost. A 40% indirect cost rate does not mean 40% of the total project cost is indirect. At a 40% rate on direct labor, indirect costs are $40 per $100 of direct cost — making indirect costs $40 of the $140 total, or only 28.6% of total cost.
FAQ
What is the indirect cost rate formula?
Indirect Cost Rate = Indirect Cost Pool ÷ Allocation Base. The pool is the total of all overhead and general expenses that cannot be directly attributed to a specific project. The allocation base is the measure used to distribute costs — commonly direct labor cost, direct labor hours, or total direct cost. Apply the rate to a project's direct cost to get the allocated indirect cost: Project Indirect Cost = Direct Cost × Rate.
What is the difference between direct costs and indirect costs?
Direct costs can be specifically identified with and traced to a particular project, product, or contract — such as a programmer's salary on a specific software project or the raw materials in a product. Indirect costs benefit multiple projects or the organization as a whole and cannot be directly assigned — such as office rent, administrative salaries, and general insurance. The line between direct and indirect must be applied consistently throughout the accounting period.
What is MTDC and when do I use it?
Modified Total Direct Cost (MTDC) is the indirect cost base required for federal grants under 2 CFR Part 200. It starts with total direct costs and excludes equipment and capital expenditures, subcontract amounts over $25,000 per subcontract, patient care costs, tuition remission, and rental costs for off-site facilities. Using MTDC instead of TDC prevents equipment-heavy grants from bearing disproportionate indirect costs.
What is the difference between an overhead rate and a G&A rate?
The overhead rate covers indirect costs of production or project delivery departments — facilities, supervision, equipment depreciation — and is applied to direct labor costs. The G&A rate covers organization-wide administrative costs — executive salaries, accounting, HR, legal — and is applied to total cost input (direct plus overhead). In government contracting, these are typically separate pools with separate rates applied in sequence.
Can I use a single blended indirect rate?
Yes, for many organizations a single blended rate that combines overhead and G&A into one pool is simpler and adequate. It works well for small organizations, sole-source contracts, or when the distinction between overhead and G&A is not material. Multi-rate structures are generally required for complex organizations with multiple cost centers, government contractors under DCAA oversight, or organizations with significant variation in project types.
How does indirect cost rate differ from overhead rate?
Overhead rate is one type of indirect cost rate — specifically the rate covering production or service delivery overhead. "Indirect cost rate" is the broader term encompassing overhead rates, G&A rates, and fringe rates. In casual usage the terms are often used interchangeably, but in government contracting and grant accounting, the distinctions are formally defined and matter for compliance and cost recovery.
What happens if my actual indirect costs differ from my applied rate?
The difference is called over-applied or under-applied overhead. If actual indirect costs are less than what the rate applied (over-applied), some projects were charged too much. If actual costs exceed what was applied (under-applied), projects were charged too little. At year-end, organizations reconcile actual vs applied costs and either adjust the rate for the next period, allocate the variance to projects, or charge the difference to cost of goods sold or general expense.