Appendix

Introduction

PURPOSE OF THE PLAN

The purpose of the City’s Cost Allocation Plan is to identify the total costs of providing specific City services. Why is a separate cost accounting analysis required to do this? Because in almost all organizations—whether in the private or the public sector—the cost of producing goods or delivering services can be classified into two basic categories: direct and indirect costs.

“Direct costs” by their nature are usually easy to identify and relate to a specific service. However, this is not the case for “indirect costs.” As such, if we want to know the “total cost” of providing a specific service, then we need to develop an approach—a plan—for reasonably allocating indirect costs to direct cost programs.

What Are Direct and Indirect Costs?

Direct costs are those that can be specifically identified with a particular cost objective, such as street maintenance, police protection and water service. Indirect costs are not readily identifiable with a direct operating program, but rather, are incurred for a joint purpose that benefits more than one cost objective.

Common examples of indirect costs include accounting, purchasing, legal services, personnel administration and building maintenance. Although indirect costs are generally not readily identifiable with direct cost programs, their cost should be included if we want to know the total cost of delivering specific services.

Budgeting and Accounting for Indirect Costs.

Theoretically, all indirect costs could be directly charged to specific cost objectives; however, the cost of doing so and the practical difficulties generally preclude such an approach for organizational and accounting reasons. As such, almost all organizations separately budget and account for direct and indirect costs at some level depending on their financial reporting needs and the complexity of their operations.

Distributing Indirect Costs.

In order to determine the total cost of delivering specific services, some methodology for determining and distributing indirect costs must be developed, and that is the purpose of cost allocation plans: to identify indirect costs and to allocate them to benefiting direct cost programs in a logical, consistent and reasonable manner.

Plan Goal: Reasonable Allocation of Costs.

It is important to stress that the goal of the Cost Allocation Plan is a reasonable allocation of indirect costs, not a “perfect” one. By their very nature, indirect costs are difficult to link with direct costs. As such, in developing an allocation approach, it is important to keep this goal in mind as we balance the cost and of effort of complicated allocation methods with the likely benefits from the end results.

INDIRECT COST ALLOCATION STRATEGIES

There are several ways of allocating indirect costs, including:

Internal Service Funds

Many cities allocate costs through formal internal service funds for services like printing, information technology, fleet maintenance and insurance. Typically, with this approach, the internal service fund provides services to the organization and charges back for departments based on their actual usage of the service and standard per-unit billing rates, like a private company would (except the goal is to break even rather than earn a profit). In this case, for the operating programs, indirect costs become direct costs, as they would if they contracted out for the service.

While this approach can result in added accounting costs to develop internal billing rates and track actual usage, it has the advantage of encouraging more efficient use of internal services by allocating costs based on actual usage, setting aside funds for long-term capital replacement needs (or in the case of insurance, adequate reserves) and helping measure performance.

As shown in the side bar, the City uses seven internal service funds to allocate organization-wide support costs.

Payroll Allocations

Some organizations allocate percentages of key support staff to selected funds through direct payroll allocations, such as 15% of the City Manager to the Water Fund or 20% of the Public Works Director to the Wastewater Fund, with direct cost distributions of non-staffing costs via accounts payable where possible.

While this practice is not uncommon, it has some conceptual drawbacks, such as the basis for the percentage allocations. One of the advantages of cost allocation plans is that the basis for the allocation is clear. Even where internal service funds are used, cost allocation plans are still often needed in allocating indirect costs to the internal service funds (so their costs reflect the full cost of providing services to the organization) and in allocating other indirect costs not typically recovered through internal service funds, such as city manager, city attorney, city clerk, human resources and accounting.

Indirect Rate

Some organizations allocate indirect costs using a standard applied rate. Regardless of the actual indirect costs incurred in any given period, an indirect rate is applied against direct costs to arrive at a simplified allocation. Examples of this type of allocation method are found in the California Uniform Cost Accounting Act.

Cost Allocation Plans

Cost allocation Plans provide a clear, consistent and reasonable basis for allocating indirect costs and are intended to allocate actual cost incurred in any given period.

Combination

Some agencies use a combination of approaches. In the City’s case, it uses a combination of internal services funds and a cost allocation plan in distributing indirect costs.

DETERMINING DIRECT AND INDIRECT COSTS

The first step in preparing the City's Cost Allocation Plan is determining direct and indirect costs. Program costs that primarily provide service to the public are identified as direct costs, whereas the cost of programs that primarily provide services to the organization are identified as indirect costs.

In accordance with generally accepted accounting principles, only operating costs are considered in preparing the Cost Allocation Plan. As such, capital outlay, debt service, interfund transfers and “pass-through” costs are excluded from the calculations. Capital costs are only used to demonstrate the effective indirect rate applied to any one department, division, or fund.

ALLOCATING INDIRECT COSTS

For general purposes, the City-wide indirect cost rate can be used as the basis for allocating indirect costs. The indirect cost rate is simply the ratio between indirect and direct costs, which can be easily computed for the City as a whole once the direct and indirect cost base has been determined. However, a key component to using a cost allocation plan as opposed to a standardized, static indirect rate is to achieve full cost allocation based on actual costs in the period in which the allocation in applied.

CITYWIDE INDIRECT COST RATE

Provided in Schedules B and C are summaries of direct and indirect costs for the City of Ukiah based on the Fiscal Year 2018-19 operating budget, along with the resulting citywide indirect cost rate. By applying the overall indirect cost rate to any specific direct cost program, the total cost of the program can be determined. For example, with an overall indirect cost rate of 17.55% the total cost for a direct program of $100,000 in Ukiah would be $117,550.

BASES OF ALLOCATION

This method of cost allocation assumes that all indirect costs are incurred proportionately to the direct cost of the program. However, this may not be a reasonable assumption in all cases, as the benefit received from certain types of support service programs may be more closely related to another indicator of activity than cost.

For example, if a program service is primarily delivered through contract and does not have any City staffing directly associated with it, distributing human resources costs to it may result in an inequitable allocation of costs. Because of this, the City’s Cost Allocation Plan establishes separate bases of allocation for each major indirect cost category. With this approach, indirect costs can be allocated to each direct cost program in a fair, convenient, and most importantly, consistent manner. Provided in Schedule A is a synopsis of the primary methods of allocation used in distributing indirect costs to direct cost programs.

Some of these costs lend themselves to an easily justified, rational approach of distribution. For example, human resources costs are related to the number of employees serviced. Other costs may not be as intuitive; however, the allocation bases are consistent with generally accepted accounting principles and recognize the concept that the cost of developing the information necessary to perform the cost allocations should not exceed the benefits likely to be gained.

Where there is not otherwise a clear relationship to another allocation base (like authorized staffing or assigned space), allocating costs based on operating budget is the common industry practice, and as such, this approach is used by the City.

INDIRECT COST ALLOCATIONS

A summary of the indirect cost allocations by fund type is provided in Schedule C, followed by the detailed allocations for each specific indirect cost program for administrative services and Overhead, as well as internal service fund use.

METHOD OF ALLOCATING COSTS

In performing the cost allocations, indirect costs have been allocated to all cost centers using a complex sequential allocation system. Although there are some conceptual difficulties with this approach, the difference in the end result was relatively insignificant. One of the primary purposes of an indirect cost allocation plan is to attempt to gauge total cost of providing services. Administrative and overhead costs centers, as well as internal fund cost centers, incur indirect costs just as their direct cost counterparts do.

As an example, under this system, the cost of the City Manager program would be allocated to the other indirect costs programs and iterative allocations then made to direct cost programs until all indirect costs are distributed. This process can be time consuming but reasonable given the intent of management and the City Council to understand total cost. However, as with the Cost Allocation Plan of the last three years, as noted above, the Plan’s goal is a reasonable allocation of indirect costs, not a “perfect” one.

USES OF THE COST ALLOCATION PLAN

By identifying total program costs, the Cost Allocation Plan can be used as an analytical tool in many financial decision-making situations, including:

Reimbursement Transfers.

The Cost Allocation Plan identifies the costs incurred by the General Fund in providing administrative support services to the City's other funds such as enterprise operations and special revenue funds. For example, the City's administrative, legal services, human resources and accounting funds are budgeted and accounted for in the General Fund; these programs provide support services to other City funds. The Cost Allocation Plan provides a clear methodology for determining this level of support in reimbursing these costs.

General Fund User Charges.

Similar to ensuring that enterprise fund revenues fully recover their costs, the Cost Allocation Plan can also be used to determine appropriate user fees for General Fund services, such as planning applications, building permits and recreation activities, in ensuring that the full cost of services are considered in setting rates.

Labor Rates.

Along with accounting for salary, benefits and paid leave (such as vacation, sick and holidays), “full cost” hourly labor rates can be developed that appropriately include indirect costs.

Contracting-Out for Services.

By identifying total costs, the cost allocation plan can also be helpful in analyzing the costs of contracting for services versus performing services in-house.

Grant Administration.

Under federal cost accounting policies, it is permissible to include indirect costs in accounting for grant programs. By establishing indirect cost rates, the cost allocation plan can be used

in recovering the total costs (direct and indirect) associated with implementing grant programs.

PLAN PREPARATION

In a total cost accounting system, indirect costs would be computed and allocated on an ongoing basis throughout the fiscal year based on actual costs. However, frequent updating in municipal finance would not serve any specific purpose—such as unit price control in a manufacturing company—rather, it would consume significant accounting resources. As such, the City’s Cost Allocation Plan is prepared annually based on the budget adopted by the Council. The Plan as included in the budget document is meant to serve as a guide as to how the allocation would be applied if actual expenditures occurred exactly as anticipated. That is never the case, however. The Plan provides estimates but actual allocations will be applied based on actual costs using the methods and basis identified in the Plan. It will be applied quarterly and reported in the City’s Quarterly Financial Report.

SUMMARY

The Cost Allocation Plan helps make determining total program costs possible by establishing a reasonable methodology for identifying and allocating indirect costs to direct cost programs. Because of this, the Cost Allocation Plan can be a valuable analytical tool in a number of situations, including establishing fees designed for full cost recovery, reimbursing support service costs provided by the General Fund to other funds, and recovering indirect costs associated with grant programs. Schedules B and C below are summaries of all indirect and subject direct costs in this plan. The overall indirect cost rate for the 2019-20 fiscal year is estimated to be 17.55% representing 15.09% of all costs, excluding transfers, capital, and debt service.

Schedule B

Allocation by Division Summary

Schedule C

Allocation by Fund Summary

Administration and Overhead

In this section administrative and overhead allocations are presented in detail by fund. Included are the inputs and calculations used to determine the overhead allocation. See the comments and notes below each schedule for additional information.

Internal Services

In this section internal service fund allocations are presented in detail by fund. Included are the inputs and calculations used to determine the allocation. See the comments and notes below each schedule for additional information.