Direct Costs vs. Indirect Costs: A Clear Guide for Nonprofit Budgets

What Are Direct Costs?

Direct costs are expenses that you can specifically identify and trace to a particular grant-funded project or program. If you can point to an expense and say "This is exclusively for Project X," it's a direct cost. These are the easiest costs to justify because the connection to your project is clear and measurable.

• Program staff salaries: Employees who work exclusively on the grant-funded project
• Project-specific supplies: Materials, equipment, or technology used solely for this program
• Direct program expenses: Participant stipends, training materials, program-specific software
• Travel for the project: Mileage, lodging, and meals directly related to program activities
• Consultants and contractors: External expertise hired specifically for this project
• Evaluation costs: Assessment tools, data collection, or evaluators working on this specific program

What Are Indirect Costs?

Indirect costs (also called overhead, administrative costs, or facilities and administrative costs) are the real costs of keeping your organization running, but they benefit multiple programs rather than just one. They're harder to assign to a specific project because they support your entire operation. These are the expenses that keep the lights on, maintain infrastructure, and enable your organization to function. Funders often scrutinize indirect costs more closely than direct costs.

• Facilities costs: Rent, mortgage, utilities, property insurance, maintenance, and janitorial services
• Administrative staff: Executive director, finance director, HR staff, and administrative assistants whose time benefits all programs
• Office operations: General office supplies, phone systems, internet, postage, and printing
• Accounting and auditing: Financial management, bookkeeping, annual audits, and tax preparation
• Legal and governance: Legal fees, board expenses, liability insurance, and compliance costs
• Technology infrastructure: Organization-wide software, IT support, website hosting, and database management
• Professional development: Staff training that benefits the entire organization

The Gray Area: Shared Costs

Some costs benefit both a specific program and the broader organization. A program director who oversees the grant project but also manages other programs represents a shared cost. You must allocate these costs proportionally based on the actual benefit received. This process is called cost allocation, and it requires thorough documentation.

• Split positions: If your program coordinator spends 60% of their time on the grant project and 40% on other work, only 60% of their salary is a direct cost
• Shared space: If the grant program uses 30% of your facility, you might allocate 30% of rent as a direct cost
• Dual-purpose equipment: A vehicle used primarily for one program but occasionally for others needs proportional allocation
• Supervisors managing multiple programs: Allocate their time based on actual oversight hours for each program
• Document your methodology: Keep timesheets, usage logs, or square footage calculations to support your allocation

Understanding Indirect Cost Rates

Your indirect cost rate is the percentage of your direct costs that you can charge to a grant for indirect expenses. For example, if you have a 15% indirect cost rate and $100,000 in direct costs, you can request $15,000 for indirect costs. This rate is calculated by dividing your total indirect costs by your total direct costs (called the modified total direct cost base, or MTDC).

• Negotiated Indirect Cost Rate Agreement (NICRA): Formal rate negotiated with a federal cognizant agency, typically valid for 2-4 years
• De minimis rate: 15% of modified total direct costs (MTDC), available to organizations without a negotiated rate under federal Uniform Guidance
• Modified total direct costs (MTDC): Direct costs minus capital expenditures, equipment over $10,000, subawards over $50,000, and certain other items
• Why get a NICRA: If your actual indirect costs exceed 10%, a negotiated rate can significantly increase grant revenue
• Foundation flexibility: Private foundations often have their own policies and may cap indirect costs at lower rates (often 10-15%)

The De Minimis Rate: Your Easiest Option

If your nonprofit doesn't have a negotiated indirect cost rate, the federal government allows you to use a de minimis rate of 15% of modified total direct costs (MTDC) for federal grants. You don't need approval, negotiation, or complex calculations. You simply charge 15% and document your direct costs properly. Many nonprofits use this option for years before pursuing a negotiated rate. For a grant with $200,000 in eligible direct costs, that's $30,000 in indirect cost recovery to support your infrastructure.

• No negotiation required: You can elect to use the 15% rate without prior approval
• Applies to federal grants: Available for grants from federal agencies under Uniform Guidance (2 CFR 200)
• Must be used consistently: Once elected for a federal award, you must use it consistently for that award period
• Consider your actual costs: If your true indirect costs are 30%, a negotiated rate would recover more
• Private foundations vary: Check each foundation's policy since not all accept the de minimis rate

Common Budget Mistakes That Get Proposals Rejected

Budget errors are among the top reasons proposals get rejected or sent back for revisions. Reviewers look for specific red flags that can derail even the strongest program design. Here's what to avoid:

• Double-dipping: Charging the same expense as both a direct cost and part of your indirect rate (this is a serious compliance violation)
• Inconsistent allocation: Listing different percentages for the same position across multiple proposals or budget documents
• Unsupported cost allocation: Claiming 100% direct cost for a staff person who clearly manages multiple programs
• Missing indirect costs entirely: Requesting only direct costs when you're entitled to recover overhead
• Exceeding funder caps: Requesting 20% indirect when the RFP clearly states a 10% maximum
• Poor budget narrative: Failing to explain and justify how costs were calculated
• Equipment vs. supplies confusion: Classifying $800 laptops as equipment (usually defined as items over $10,000)

How to Build a Compliant Grant Budget

Creating an accurate, compliant budget requires methodical planning and clear documentation. Follow these steps to build budgets that reviewers trust:

• Start with your cost allocation plan: Document how you'll assign shared costs across programs
• Review funder guidelines carefully: Look for indirect cost caps, unallowable costs, and specific budget format requirements
• Calculate salaries with fringe benefits: Include FICA, unemployment insurance, health insurance, and retirement (typically 25-35% of salary)
• Separate direct and indirect clearly: Create distinct budget line items and don't mix categories
• Use actual cost data: Base estimates on your organization's real expenses, not industry averages
• Write a detailed budget narrative: Explain the calculation for every line item, including FTE percentages and hourly rates
• Align with your proposal: Ensure every budget item corresponds to activities described in your narrative
• Have someone else review it: Fresh eyes catch errors and inconsistencies you might miss

When to Pursue a Negotiated Indirect Cost Rate

If your organization regularly applies for federal grants and your actual indirect costs exceed 15%, pursuing a Negotiated Indirect Cost Rate Agreement (NICRA) becomes worthwhile. Organizations with negotiated rates typically have rates between 20% and 40%, allowing them to recover significantly more overhead costs. The process requires detailed financial analysis and documentation, but the increased recovery justifies the effort over time. For example, a nonprofit with $1 million in eligible direct costs would recover $150,000 with the 15% de minimis rate, but $300,000 with a 30% negotiated rate. That's an additional $150,000 in annual overhead recovery.

• Best candidates: Organizations with multiple federal grants, complex operations, or actual overhead costs exceeding 20%
• Timeline: Plan for 6 to 12 months from initial contact to final approval
• You'll need an indirect cost rate proposal: This document details all indirect costs and your allocation methodology
• Your cognizant agency: The federal agency that provides the most funding typically negotiates your rate
• Valid for multiple years: Most NICRAs are approved for 2-4 years, providing rate stability
• Consider hiring help: Many nonprofits hire consultants to prepare the proposal, especially for their first NICRA
• Once approved, all federal funders must honor it: Your NICRA is recognized across all federal agencies

What Counts as Modified Total Direct Costs (MTDC)?

When calculating your de minimis rate or a negotiated indirect rate based on MTDC, not all direct costs are included in the base. Understanding what's excluded prevents calculation errors:

• Include in MTDC: Salaries and wages, fringe benefits, materials and supplies, services, travel, and subawards up to the first $50,000
• Exclude from MTDC: Equipment and capital expenditures, portions of subawards over $50,000 per subawardee, rental costs of off-site facilities, participant support costs, and scholarships/fellowships
• Why these exclusions matter: They prevent distorting the indirect rate when large equipment purchases or subawards are involved
• Example calculation: $200,000 grant with $150,000 in MTDC-eligible costs and $50,000 in equipment (excluded). Your 15% de minimis rate applies only to the $150,000, yielding $22,500 in indirect costs

Private Foundation Indirect Cost Policies

Private foundations often have different indirect cost policies than federal agencies. Some limit indirect costs to 10-15%, others prohibit them entirely, and a growing number now support full cost recovery. Always check the foundation's guidelines before budgeting.

• Some foundations cap indirect costs: Common limits are 10%, 15%, or 20% of total project costs
• Others exclude them entirely: Particularly foundations with specific program priorities or donor restrictions
• Growing trend toward full cost recovery: Many progressive foundations now accept negotiated rates or higher percentages
• Read the guidelines: If unstated, contact the program officer to ask about their indirect cost policy
• Budget creatively within caps: If limited to 10%, ensure your direct cost categories are comprehensive
• Some allow direct allocation instead: Rather than an indirect rate, itemize administrative costs as direct expenses

Documentation and Record-Keeping Requirements

Proper documentation is a compliance requirement, not just good practice. During audits or monitoring visits, you must prove that costs charged to grants are accurate, allowable, and properly allocated. Poor documentation can result in disallowed costs, required refunds, and damaged funder relationships.

• Timesheets for all staff: Track actual hours worked on each grant, even for salaried employees
• Personnel Activity Reports (PARs): Required for staff charged to federal grants, documenting percentage of time on each project
• Cost allocation methodology: Written documentation explaining how you allocate shared costs
• Salary calculations: Show how you arrived at the FTE percentages and amounts for each position
• Receipts and invoices: Retain all supporting documentation for purchases charged to grants
• General ledger coding: Maintain separate accounting codes for each grant and cost category
• Quarterly budget tracking: Monitor spending against approved budgets and document any variances
• Retention requirements: Keep records for at least 3 years after final financial report submission (some grants require longer)

Unallowable Costs: What You Can't Charge

Federal Uniform Guidance and most foundation policies explicitly prohibit certain costs. Attempting to charge these costs can result in rejected proposals, disallowed expenses, or investigations. Understanding unallowable costs is critical for compliance:

• Lobbying and political activity: Costs related to influencing legislation or political campaigns
• Fundraising: Development staff salaries, fundraising events, donor cultivation activities
• Bad debts: Uncollectible accounts and losses on loans
• Entertainment: Social activities, amusement, and recreation costs
• Fines and penalties: Legal judgments, traffic tickets, late fees
• Interest on borrowing: Debt service and interest payments (with limited exceptions)
• Contributions and donations: Gifts to other organizations
• Pre-award costs: Expenses incurred before the grant start date (unless explicitly approved)

How GrantCopilot Helps with Budget Development

GrantCopilot's Compass includes budget templates tailored to different funder types, with built-in guidance on direct vs. indirect cost categorization. The workspace helps you organize budget line items and generate clear budget narratives that explain your methodology to reviewers. You can save standard budget items (like fringe benefit rates and common supplies) and reuse them across proposals, ensuring consistency and saving time.

Sources & Additional Resources

This guide is based on current federal regulations and nonprofit financial management best practices. Key regulatory sources include:

• OMB Uniform Guidance (2 CFR 200): The complete federal regulations governing grants and cooperative agreements, including cost principles and administrative requirements. Available at ecfr.gov
• 2 CFR 200.414 - Indirect (F&A) costs: Specific regulations on indirect cost rates, de minimis rate election, and MTDC calculation
• 2 CFR 200.68 - Modified Total Direct Cost (MTDC): Definition of MTDC base and excluded costs
• 2 CFR 200.1 - Definitions: Equipment threshold definitions and other key terms
• 2 CFR 200.420-200.475 - Unallowable Costs: Complete list of costs that cannot be charged to federal awards
• National Council of Nonprofits: Provides nonprofit-specific guidance on indirect costs and federal compliance at councilofnonprofits.org
• Nonprofit organizations should consult with their cognizant federal agency for specific guidance on NICRA applications and indirect cost rate negotiations