M M E E D D A A I I R R : :
th t h e e s s u u r r v v iv i va a l l o o f f in i n d d ir i r e e c c t t c c os o s t t s s
Janna Johanna Tolhoek
RijksUniversiteit Groningen Faculteit Bedrijfskunde
October 2003
M M E E D D A A I I R R : :
t t h h e e s s u u r r v v i i v v a a l l o o f f i i n n d d i i r r e e c c t t c c o o s s t t s s
Janna Johanna Tolhoek (1064983)
Supervisors:
E.P. Jansen A.D. Wansink J. Rigstad (Medair)
Ecublens (CH), October 2003
The author is responsible for the contents of this thesis. The copyright rests with the
author.
“Whoever can be trusted with very little can also be trusted with much, and whoever is dishonest with very little will also be dishonest with much ...
And if you have not been trustworthy with someone else’s property, who will give you property of your own?”
(Bible, Luke 16: 10, 12)
Preface
In your hands, you have my thesis, which I have written for Medair HQ in Ecublens, Switzerland. This research was the last part of my university degree in Management &
Organization – Accountancy at the RijksUniversiteit Groningen. The subject is about the indirect cost allocation. It compares the method Medair uses with theoretical methods learned at the University and it gives suggestions for a better approach.
By doing this research I have learnt a lot, not only through reading the theory and doing the research, but also through working as a finance officer. In that position I was responsible for supporting and assisting the field accounting, reviewing project budgets, preparing BvAs, coordinating cash requirements for the field projects, preparing the final financial reports and so on. Doing research was like climbing a mountain. You start very positive and set the goal to reach the top. During the way you discover you do not have the right equipment and it becomes a struggle. Later on, every step is almost one too much. Although I finished my research, I do not feel I have reached the top.
I want to say thanks to all my dear Medair colleagues for the fantastic and wonderful time they gave me in Switzerland. You are a great bunch of special people. Thanks for all encouragement and sharing the joy of receiving my degree! Do not worry; my time is not over at Medair. I will stay as finance person, only changing the location to Kabul.
Particularly I want to thank John Rigstad for giving me the possibility to do my thesis at Medair and for motivating and stimulating me. I want to thank him specially for his feedback and for the responsibilities he gave me. I have learnt so much from this.
Thanks to Dirk Bouma for reading and correcting my thesis. Without your help, I did not have such a well-written thesis. I also want to thank you for the feedback and suggestions you gave during the interesting discussions!
Furthermore, I want to say many thanks to my supervisors from the University: Pieter Jansen and Dick Wansink. Through your supervising, advising and feedback the quality of my research improved.
Last but not least I thank my family for their support. Although they were in the
Netherlands, their support and e-mails were always welcome. Mem, Heit, Richt & Henk,
Lien, Petra and Jaap: THANKS for encouraging, visiting and supporting me!
Summary
Indirect costs and the allocation of those costs have been discussions for decades and are still ongoing. The indirect costs are an ever-recurring topic that will be discussed. This paper is about the indirect costs and the allocation to the cost objects. It is written for Medair, a non-profit, non-governmental organization.
Medair has been established in 1988 in Switzerland. Medair headquarters (HQ) coordinates the field projects and provides support through its four departments:
Human Resources, Communication & Fundraising, Operations and Finances. At the moment it runs projects in 9 countries, often more projects in one country, with a total staff of about 100 expatriates and 700 local staff. The projects are the core activities for Medair. To run the projects effectively and efficiently, project planning and monitoring is critical. Therefore budgets, accounts and reports are essential tools to manage the projects. Good financial management is critical because Medair has to be transparent and accountable to their stakeholders, especially to their donors. The stakeholders provide the resources to Medair to run the projects. Before starting a project, a project budget will be made and approved by the donor. During the implementation of the project, the budget is an important guideline to explain how the money should be spent.
The budget is divided into different categories following the chart of accounts. Monthly the budget will be compared with the total actual expenses to monitor and evaluate the project. After finishing the project, the final report will be made and sent to the donor.
The project budget can be divided into two cost categories: direct and indirect.
According to Medair the direct costs are all the project costs including the HQ staff evaluation visits. All other costs are seen as indirect costs. Those costs are allocated to the project by using the simplified method. This means that above the direct costs 10 percent will be charged to cover the indirect costs. There is already a gap between the real indirect costs, 14 percent in 2002, and the charged costs, 10 percent. Most donors do not want to cover the full 10 percent. This percentage is needed to cover the HQ costs.
HQ is coordinating and monitoring the projects. If the donors do not cover the indirect costs, how will it be covered then? Is it possible to define the direct and indirect costs in a different way or use a different allocation method?
This leads to the goal of the paper:
“the goal for this research is to analyze the indirect cost allocation method for Medair and compare it with the theoretical indirect cost allocation methods to find the best possible allocation method for Medair considering the donor restrictions for the indirect costs.”
The donor restrictions influence Medair’s cost allocation method. They set restrictions for Medair. Medair is using the simplified method to allocate the indirect costs to the cost object, the projects. This method does not cover the full indirect cost anymore.
Medair’s method will be analyzed with the theoretical allocation methods. This analysis
will give insights how Medair can improve their allocation. The donor restrictions are
the limits for the recommendations to Medair.
The central goal has been translated into the central research question:
“What is the best possible indirect cost allocation method for Medair and how can it be applied?”
This question has been split into three tangible sub-questions:
1. Which theoretical methods are there for allocating indirect costs?
Before describing the theoretical methods a few definitions have to be explained: cost object, direct costs and indirect costs. A cost object is an object which asks for a separate measurement of costs. This object will carry the total costs. Direct costs can be directly traced to and identified with the cost object. Indirect costs cannot be traced in an economically feasible and cost-effective way. It is hardly possible to attach indirect costs accurately to the cost object in an efficient way. Therefore, several allocation methods have been designed:
- the Simplified Method. The cost object will carry the direct costs plus a fixed percentage to cover the indirect costs.
- the Multiple Allocation Base Method. Between the indirect cost categories and the allocation percentages exist a relation. The costs to the object are calculated by taking the direct cost and the several percentages to cover the indirect cost categories.
- the Two-Stage Method. In the first stage, the organizational indirect costs will be allocated to the operating centres. In the second stage, all costs in the operating centres will be allocated to the cost object by using a cost driver.
- Activity Based Costing (ABC) method. According to the ABC method activities causes costs and cost objects demand for activities. The ABC method creates a link between activities and cost objects by assigning costs of activities to objects based on the object’s consumption or demand for each activity and cutting across departmental boundaries. This method uses several different cost drivers to allocate the activities to the cost objects.
2. What are the donor restrictions for Medair concentrated on the use of the indirect cost methods?
Medair groups the donors into three categories:
•
Governmental and International Donors (GID)
•
Institutional Private Donors
•
Private Donors
The focus will be on the GIDs, because they fund the larger part of the projects. Out of the fourteen GIDs only two GIDs will pay the 10 percent Medair is asking for. The others are paying between the 0 and 7 percent, in two cases this percentage should also cover the field administrative expenses. This means that the outstanding balance has to be covered by private funding. Those donors define also direct and indirect cost through their budget templates. About the allocation methods, only one GID sets restrictions.
This donor does approve the simplified allocation method, the multiple allocation base method, the direct allocation method and special indirect cost rates.
3. How can it be applied to Medair in relation to the donor restrictions?
To answer this question some critical methodological choices have to be made. The users
of the cost allocation information are the MT, StratCom and BoT. They will use it to
make (strategic) decisions to monitor and to control the indirect costs. The definition for indirect costs is dependent on the organizational structure. If Medair can decentralize more work or people, the indirect costs will decline. The costs should be allocated to the projects split into five categories: beneficiary costs, logistics and transport costs, direct project support costs, indirect project support costs and HQ costs. The indirect support costs will be allocated to the project by using the two-stage method. The first stage contains the allocation of the salaries and benefits of the DOs, HROs and FOs to the countries. To allocate those costs the ratio between the countries sizes, which are under the DO’s, HRO’s or FO’s responsibility, will be used. In the second stage the total indirect support cost per country will be split over the projects. Here the project size is taken as a percentage of the overall country size. The indirect support costs per project will be calculated by taking this percentage times the country indirect support costs.
The remaining HQ costs will be allocated to the projects by using the simplified method.
This percentage can be reduced, because half of the HQ salaries and benefits have
already been allocated to the projects as indirect support costs.
Table of Contents
Preface 4
Summary 5
Table of Contents 8
Chapter 1 Introduction 10
Chapter 2 Medair: the survival to life 12
§2.1 Introduction 12
§2.2 Medair Structure 13
§2.2.1 Organizational Structure 13
§2.2.2 HQ Structure 14
§2.3 Financial Management 15
Chapter 3 Research Assignment 16
§3.1 Profit and Non-Profit Organizations 16
§3.2 Background 17
§3.2.1 Information Users 22
§3.3 Central Research Goal 22
§3.3.1 Central research question 23
§3.3.2 Sub-questions and data collecting 23
§3.3.3 Conceptual model 26
§3.4 Research Definition 27
§3.4.1 Definition 27
§3.4.2 Quality 28
Chapter 4 Indirect cost allocation methods 29
§4.1 Cost allocation 29
§4.2 Cost allocation methods 30
§4.2.1 Traditional costing systems 31
§4.2.1.1 Simplified and Multiple Allocation Base Method 31
§4.2.1.2 Two-stage procedure 33
§4.2.2 Activity-Based Costing method 37
§4.2.2.1 How the method works 38
§4.3 Overview 42
Chapter 5 Donor Restrictions 43
§5.1 Medair’s Governmental and International Donors 43
§5.2 Restrictions per GID 44
§5.2.1 BuZa 44
§5.2.2 CIDA 44
§5.2.3 DDC 45
§5.2.4 DfID 45
§5.2.5 ECHO 46
§5.2.6 JICA 47
§5.2.7 SIDA 47
§5.2.8 United Nations: UN FAO, UNHCR, UNICEF, UNOCHA, WFP 48
§5.2.9 USAID and OFDA 48
§5.3 Summary Table 51
Chapter 6 Conclusions and Recommendations 53
§6.1 Users of the method 53
§6.2 Method Choices 54
§6.2.1 Cost object 54
§6.2.2 Classification of costs 54
§6.2.3 Cost allocation methods 56
§6.2.4 Cost driver 57
§6.3 Design 58
§6.4 Summary 58
Chapter 7 Final Conclusion 60
References 61
CHAPTER 1 Introduction
Indirect costs and the allocation of those cost was already a discussion years and years ago, and is still ongoing today. The indirect costs are especially a delicate subject in the non-profit, non-governmental world; for instance think about Foster Parents Plan, a Dutch non-profit organization. A few years ago, this organization was in the news with several issues, all about using donor money wisely. One issue was about the payment of a top salary to the interim director. The interim director earned as much as a director in a profit organization. In 2002, almost 12 percent of the total income was used for salaries.
Of course, non-profits need good manager to lead the organization and not only idealists. Professionals are necessary to improve the quality of work. However, is it not a choice the employee makes to work for a non-profit instead of profit organization? The consequence will often be that the salary is lower than in corporate business. Non-profits receive money form donors and they have to justify their expenses. Another appearing issue was that a relatively small percentage of the total income went to the beneficiaries, the children in developing countries. What has happened with the remaining relatively high amount?
The indirect costs are and will continue to be a precarious topic for non-profit organizations (NPO) and their stakeholders. NPOs receive money from donors and they are accountable to them how they use it. The donors desire that a high percentage of their money will be used to improve people’s life conditions in third world countries. If NPOs use the given gifts and grants for top salaries, as Foster Parents Plan did, can they justify that? They receive the money to fulfill their mission and they should use it in an efficient and effective way.
Often donors do not want to cover the total indirect costs, but they will give a certain amount for those costs. Why only a certain amount? In daily life, we are also paying for the indirect costs of other companies. If you go to a supermarket and buy a bottle of milk, you will pay also for the rent of the building, the electricity, salaries and so on. It is all included in the price of the cost object. A NPO is in this way not different from a profit organization. In addition, a non-profit has indirect costs and need to cover them.
They do not generate money, so they have to find a way to cover those costs.
What is the reason that donors do not fully cover the indirect costs? It has several reasons. For instance, the governmental donors are also accountable to their stakeholders. They want to reflect to their stakeholders a high percentage directly used for beneficiaries. Their money has been used in an effective way. The other reason is that if donors will cover the total indirect costs, there is a possibility that the NGO will not try to reduce the indirect costs to work efficiently. Here the example above is applicable.
Foster Parents Plan did not use the given money in an effective way. Many stakeholders
did not agree with their way of spending their money and they decided to stop funding
the organization. If their money is used to cover indirect costs like high salaries, than of
course donors set their restrictions how NPOs have to use their money. And the donors
set indeed restrictions and have requirements on how the NPO has to spend their
money.
The allocation of indirect costs has been a discussion for many decades. One of the reasons for continuing the discussion is because organizations do not have fully control over those costs. Whatever they do, the costs will be there. It is an inescapable problem.
Every organization will face it and has to decide which allocation method will be used.
There are different methods how to allocate the costs to the cost object: the traditional methods and the Activity Based Costing method. Cooper and Kaplan have developed the last method in the eighties. Organizations choose the best suitable method to allocate the costs to the cost object. Which method suits best for an organization depends on the circumstances and on the information needed for taking strategic decisions. The choice is made on a subjective base, not one method will be the best.
The subject of this research is about the indirect cost allocation for Medair. Medair is a non-profit, non-governmental organization. The aim of Medair is to respond to crisis situations by running relief and rehabilitation projects. Medair provides assistance to victims of natural disasters, war situations or other catastrophic events; especially crises that are not highlighted in the media involving forgotten people, yesterday’s wars, resettlement of refugees and so on. They work to prevent and alleviate the suffering, protect life and health with respect for human dignity by providing the basic requirements to meet people’s needs for adequate water, sanitation, nutrition, food, shelter and health care does this.
Medair’s total indirect costs are higher than the amounts given by donors to cover the
indirect costs. The question is if Medair will change the method, will donors cover a
larger or the total amount of the indirect costs? This research will try to find an answer
for this question. In the next chapter, the organization Medair will be introduced to give
the background for this research. Chapter 3 will be about the research set-up and the
reason for this research. Here will be described the way the research will be approached
and what the central research goal and question is. The central question will be split into
tangible sub-questions. Those questions will be answered in the next chapters. Chapter 4
will deal with the theory about the allocation methods. The methods can be split into
two groups: the traditional methods and the Activity Based Costing method. In the
following chapter, the requirements and restrictions set by the Governmental and
International donors will be portrayed. These restrictions are limits for the
recommendations to Medair. Chapter 6 will contain the conclusion and
recommendations to Medair. The last chapter will be the end conclusion of this research.
CHAPTER 2 Medair: the survival to life
… In order to reach the County of Sinoe (Liberia), we have to pass through dozens of military road blocks to Greenville, where we are received at the home of the lady mayor of the town. The entire medical system needs to be reinstated. To our astonishment, the regional health authorities present their request to us in this way:
“If you give us free medicines, we shall be dependent on you and the system will fall apart again after Medair leaves. Could you rather help us to reinstate a revolving drug fund where the working capital will also enable us to pay our costs, salaries and transport? Such a system will give us the autonomy that we had before the war.”
This is a new challenge for a medical team: to institute a system of autonomous management with health care that must be paid for, to motivate, encourage, and supervise, to repair structures, to retrain the local medical personnel, and to stock a pharmacy that is starting again from scratch…
(Bread and Salt. The History of MEDAIR, by Josiane Volkmar-André, p. 52)
§ 2.1 Introduction to Medair
“The mission of Medair is to respond to human suffering in emergency and disaster situations by implementing multisectorial relief and rehabilitation projects, in a
compassionate and serving attitude inspired by its Christian ethos.”
The famine in Chad in the eighties was the birthplace for a new humanitarian organization conceived by people from Médicaments pour l’Afrique (Medaf) and Mission Aviation Fellowship (MAF) who analyzed the existing aid programme. They saw the need to create an emergency Christian aid organization, which should be able to act quickly in case of emergencies like wars and natural disasters. This organization was given the name MEDAIR. In 1987, a few years after the Chad famine, Medair’s concept and name was born. Youth with a Mission (YWAM) joined Medaf and MAF to realize the new organization. In June 1988, the foundations for the partnership were laid.
Medair has been established as a non-governmental organization, independent of any political, economic, social and religious authority.
Erik and Josiane Volkmar were willing to lead the organization. The first project was launched in North East Uganda in 1988 with a budget of $3,000 and two expatriates. In July of 1989, the Uganda project was finished and Sudan was foreseen as the next place to intervene. Surveys were done in Mozambique, Kurdistan and Sudan. In 1990 the Sudan project was started. In addition, the first seminar, a preparation course for the field, took place.
In 1991, Medair extended its presence from one country to three: Sudan, Liberia and
Iraq. In the same year, Medair opened its first office in Lausanne, Switzerland. One year
later the first Leadership Meeting took place. Those attending stressed the need for more
support from the headquarters in Switzerland and more professionalism. In 1995 Medair
adopted a new structure to be faster in decision making in order to get a more effective response; in so doing it became independent of the three organizations: Medaf, MAF and YWAM.
Three years later the first three-year-strategy plan was prepared. One of the main goals was to increase the number of projects to nine projects in the following three years. In 2000, the office in Lausanne was too small. There were at that time 12 people working and the office moved to Ecublens. In 2001, a new strategy plan was adopted. Quality has been important for Medair since the beginning. To improve quality Medair developed a quality management system through which it obtained the ISO (International Organization for Standardization) 9001:2000 certification, one of the first humanitarian NGOs to do so worldwide. Also in 2001, the headquarters was restructured and has been divided into four departments: Communication & Fund Raising, Human Resources, Operations and Finances. One year later, the Medair website was launched incorporating a new organizational image.
Since 1988, Medair has run projects in the following countries: Afghanistan, Albania Armenia, Bangladesh, Chad, Chechnya, DR Congo, India, Kenya, Kosovo, Liberia, Mozambique, North Caucasus, Northern Iraq, North and South Sudan, Rwanda, Somalia and Uganda.
Medair currently has projects in Afghanistan, Angola, DR Congo, Iraq, Madagascar, North and South Sudan, Uganda and Zimbabwe.
§ 2.2 Medair Structure
The international headquarters is based in Ecublens, Switzerland. About 25 people are working there to assist about 100 expatriates and circa 700 local staff. Medair has national offices in Canada, France, Germany, the Netherlands and United Kingdom. The national offices support the operations of Medair Switzerland in the areas of recruiting field personnel, fundraising for Medair projects and operations, promotion of Medair, and providing tax and insurance facilities for nationals working on Medair projects.
The following sections explain the overall organizational structure of Medair and the Headquarters (HQ) structure.
§ 2.2.1 Organizational structure
The organizational structure can be divided into three parts (see Appendix 1): a legal part, an executive part and a field part.
The legal part consists of the Members of the Medair Association and the Board of Trustees (BoT). The Members meet once a year in Switzerland for the General Assembly.
They commit to support the work of Medair morally, materially and spiritually and they
elect the BoT members. The BoT meets also once a year and is composed of 9 to 15
members. The BoT is responsible for ensuring that the staff adheres to the vision and
values of Medair. The BoT also appoints the Chief Executive Officer (CEO), and approves and monitors the one - and three - year strategic plans.
The executive structure consists of the Strategic Committee (StratCom) and the Management Team (MT).
The StratCom is the operational leadership and management body of the organization that supports the CEO. The Committee is composed of 10 members: the MT, 2 members of the BoT, and 2 senior Country Directors. They are responsible for decision-making on the location of new projects, strategy and long-term planning.
The MT consists of the CEO, the Human Resource Director, the Communication and Fundraising Director, the Finance Director, the Operations Director and the Operations Manager & Quality Director. The MT is responsible for the overall work of Medair, for the field projects, the Relief/Rehabilitation Orientation Courses (ROC), finances, public relations and communication. The MT reports to the BoT and StratCom.
The field part is covered by the field teams. The teams exist of volunteers, each of them with different responsibilities depending on project needs. The team leader reports to the Country Director (CD) who is responsible for all aspects of the project. The DO is in daily contact with the CD to advise on issues, to communicate with authorities and funding partners and to help with logistics. The DO and CD work alongside the HRO.
The HRO is responsible for recruiting and selecting volunteers to staff the projects and caring for them.
§ 2.2.2 HQ structure
Medair HQ coordinates all current and potential field projects, providing support through its four departments: Human Resources, Communication & Fundraising, Operations and Finances (see Appendix 2).
The Human Resources department is responsible for recruiting and selecting volunteers and staff for the projects in the field and also for HQ. One of the tools for recruiting staff is the Relief/Rehabilitation Orientation Course (ROC). The ROC is held tree times a year in countries where Medair has a national presence and is a preparation for the field.
Further more this department briefs and debriefs the expatriates before going to the field, during their fieldwork and after coming back. The Human Resources Officers and Human Resources Assistants are responsible to the Human Resources Director (HRD).
The HRD has to report to the CEO.
The Communication & Fundraising department is responsible for communicating and promoting Medair to the outside world by having stands at different conferences, advertising, updating and maintaining the website, publishing newsletters and so on.
Furthermore, they do fundraising for Medair projects and operations. The different employees in this department report to the Communication and Fundraising Director.
He is responsible to the CEO.
The Operations Department is responsible to lead and support the field projects in accordance with Medair’s mandate, values and quality standard. They are also in charge of raising, managing and reporting on institutional grants and they are responsible together with the CD for initiation, management, and completion of Medair’s projects.
The DO and Logistic Coordinator are answerable to the Operations Director and she is
responsible to the CEO.
The Finance Department is responsible to support the field operations with timely and accurate financial reports: budgets, budget versus total performing, standard cost analysis, interim and final financial reports. This responsibility falls under its overall general responsibility for HQ financial functions. The Finance Officers and Accounting Assistants are accountable to the Finance Director who reports to the CEO.
§ 2.3 Financial Management
Financial management is one of Medair’s key principles to successful management.
Financial management is critical because Medair has to be accountable and transparent to its stakeholders, especially donors. Medair receives grants and gifts from donors to be able to implement projects. It is important to be transparent to maintain them as donors.
Donors need to know how their grants will be and have been spent on the projects.
Transparency depends on good and accurate financial management. Financial management is also critically important in the value-system of Medair in that it believes in the necessity of good stewardship of resources. Because Medair gets resources from donors and other stakeholders, it wants to use them as efficiently and effectively as possible. Furthermore, financial management is seen by Medair as important for good project management. Good financial management is made up of different components:
budgets, accounts and reports. These are all linked together. Budgets are a necessary tool for project planning, while accounts and reports are the tools for project monitoring (both internal and external). All projects have budgets to which they must adhere. A well-prepared budget is a critical condition for a well-implemented project; like an old Chinese proverb says: ‘failing to plan is planning to fail’. Project budgets are approved by the donors to those projects and are integral to the success of each project plan expressed. Tracking financial progress of a project is a key function of the project manager and requires good financial management.
The Chart of Accounts lies at the centre of all financial operations. It is the document containing codes that designate all the categories of income and expenses from which Medair manages its finances. These categories form the line-items of each project.
Monthly the actual expenses are compared with budget lines, the differences must be analyzed by the DO and Financial Officer and corrective steps can be taken. Regularly Medair reports on its activities to donors, local authorities and internal management.
Chapter 3 will discuss Medair’s financial management in more detail.
CHAPTER 3 Research Assignment
This chapter contains the research set-up; this means how the research will be approached. The chapter begins with explaining the differences and similarities between profit and non-profit organizations. Furthermore the background of the research will be described, the reason why this research is necessary. The background leads to the central research goal and question. This chapter ends with the methodology of the research, how will the central question be answered?
§3.1 Profit and Non-profit Organizations
Organizations can be classified into two different types: Profit and Non-Profit Organizations (NPO). The main goal of a profit organization is to maximize their gain, to generate the highest profit for their organization. The managers in the profit organization take certain decisions with a view to get the most profit out of their organization. NPOs have other objectives than making profit. A NPO exists to provide a particular service to the community. The objectives depend on the kind of NPO. For example, a service organization could have an objective like ‘rendering a good quality of social services’, a humanitarian organization could have ‘to give help to refuges and victims of disasters’. The word ‘nonprofit’ refers to a type of business, which is organized under rules that forbid the distribution of profits to owners
1. NPOs have a responsibility to be accountable for the funds they receive. This responsibility includes accounting for certain specific funds that have been given for use in a particular project, as well as general obligation to employ the organization’s resources effectively.
Emphasis is placed on accountability and stewardship.
Although there are various differences between profit organizations and NPOs in the way they operate, the fundamental accounting principles can be applied to both kind of organizations (Blommaert et al., 1993). Because profit organizations and NPOs use money to operate, use budgets and implement control systems. For both kinds of organizations, money is the source of existence, the lifeblood of the organization.
NPOs can be further distinguished into Governmental and Non-Governmental Organizations. A Governmental Organization is for example the Federal or State Government. Educational organizations can be a public, governmental, or a private, non-governmental, organization; it depends on the country. A NGO is organized outside of institutionalized political structures to realize social objectives, like e.g.
human rights issues, humanitarian aid, environmental issues et cetera
2. According to the United Nations,
3a NGO is any NPO, which is organized on a local, national or international level; task-oriented and driven by people with a common interest; NGOs
1 www.not-for-profit.org
2 www.library.pitt.edu
3 www.ngos.net
perform a variety of services and humanitarian functions, bring citizens' concerns to Governments, monitor policies and encourage political participation at the community level. NGOs can be distinguished in different subjects, for example health care, charitable, literary, artistic, environmental, science research et cetera.
Medair can be classified as a charitable NGO with the focus on humanitarian aid in forgotten crisis situations.
§3.2 Background
For many years, the cost allocation problem is an important issue in management accounting literature. Many articles have been written about this subject, but there is not one right answer for what the best way is to allocate the indirect costs. The answer organizations have for the cost allocation problem is seldom clearly right or wrong. The allocation problem is not only a problem for the profit organizations, but also for the NPOs. In profit organizations and NPOs, both need to know the total (direct and indirect) costs of a product, service, project et cetera, to control those costs. Although there are differences in the goals and objectives for profit organizations and NPOs, the accounting principles are also applicable to NPOs as mention in paragraph § 3.1.
There are advocates and adversaries for allocating indirect costs. The adversaries say that the allocation is never totally objective, because the organization has to choose the method for allocation. A different method gives different outcomes, because there is no causal relation between the indirect costs and the cost object. In addition, employees responsible for a cost centre cannot control the indirect costs; those costs are not directly identifiable with their product, service or project. Why should you allocate them then?
And the allocation of indirect cost entails costs, so the allocation creates even extra costs and what to do with them?
However, on the other side, there are arguments to do the allocation of indirect costs.
The advocates say that by allocating the costs, the organization as a whole is taken. The managers are taking care of the whole organization instead of only their part. This will make the organization in total a team instead of individuals only caring for their part.
Although they cannot control the total of the indirect costs, they can control part of it.
And if every responsible person takes care of it and uses it efficient, the total indirect costs will decline. Indeed, it entails cost to allocate the indirect cost. But to be competitive the organization has to know exactly what the costs of operation are in order to get an effective sell price. For that reason, the supporting department costs have to be allocated to the cost objects. Also the indirect costs have to be allocated to the cost object for making decisions.
Medair has different projects at different field locations. The projects are the core
activities of Medair and are implementing the organization’s mandate. A project has a
clear beginning and end; a clear goal or objective; a team of people with different skills
to form the project team and implement the activities; and initiated or requested by
certain stakeholders: beneficiaries, donors et cetera. Medair’s project cycle consists of six
phases with six decisions. Medair uses the project cycle to have a transparent, collective
and co-ordinated decision every time moving from one phase to the other. When a crisis
happens and the ‘start-up’ decision is given, phase one starts ‘the Research’. In this phase, the goal is to find out whether Medair can participate in this crisis. After the research phase, the ‘survey’ decision is taken and phase two ‘Survey’ begins. Here Medair finds out how it can help and what kind of projects are necessary to help the beneficiaries. When the survey is done, one of the most important decisions has to be taken: the ‘Go/No-Go’ decision. If the decision is ‘go’, a proposal has to be made (‘Proposal’ phase). A project has to be defined and presented to donors. Furthermore, everything has to be prepared to make the implementation impeccable. After this phase, the ‘implementation’ decision has to be taken and phase four begins ‘Implementation’;
the realization of the project. When the project is finished, the decision for evaluation has to be made and in the ‘Evaluation’ phase Medair checks how the project has been carried out and what it has learnt by doing this project. The last decision is the ‘exit’ decision (also possible to go back to ‘Proposal’ phase for follow-up project) and the last phase is the ‘Exit’ phase; the hand over of the project parts to (local) counterparts.
Figure 3.1 Project Cycle4
All projects are supported and coordinated by Medair HQ. Without Medair HQ, there are no projects at all as shown in figure 3.2. That means that HQ costs are part of the running costs. How should these costs be allocated to the different projects?
Every project is actually a new one, because of the different and unforeseen circumstances: often a new country and limiting conditions. Figure 3.2 shows that the different projects have different sizes and need different support from HQ. One country has often more projects running at the same time. This acquires more support and co- ordination from HQ to run the projects as effectively and efficiently as possible. Also the
4 Medair Quality Manual 2003
Crisis
RESEARCH
SURVEY
PROPOSAL
IMPLEMENTATIONEVALUATION EXIT
Start-up decision
Survey decision
Go/No-Go decision Implementation
decision Evaluation decision
Exit decision
projects in one country need to be co-ordinated to run efficiently and effectively. There will be for example one administrative base for all projects, one house, shared cars and so on. These things will be shared among the different running projects. That means that the projects are intertwined with each other.
Because of all the differences between projects, the management of a project becomes extremely important. The success of a project is dependant upon the level of control of several factors: Money, Organization, Time, Information, Communication and Quality.
All together, they determine the end result. I will only pay attention to the Money control factor, because this one is important to understand how Medair allocates the indirect costs.
Figure 3.2 Relationship HQ-projects
In the survey phase, estimation is made about the costs of the potential project. This is necessary to know if the project is feasible.
During the proposal phase, the project budget is made and Medair tries to get donors involved to fund the project through describing to the donor the nature and necessity of Medair’s involvement. The budget is more accurate than the estimation in the phase before. For Medair the cost object is the different projects running on different locations.
A budget is made for every project. This is a guideline of how much money can be spent on a particular expense line according to the chart of accounts. With each donor, Medair has to agree in advance the project budget. The budget reflects the best possible estimate
HEADQUARTERS
COUNTRY 1
COUNTRY 2
COUNTRY 3
Project 2A
Project 2B
Project 2C
Project 3A Project 3B Project 1A
Project 1B
of the costs of the project in a certain time frame and it is a strong control mechanism.
Each project budget includes a 10 percent administrative cost that has to be paid to HQ regardless of whether a donor will actually pay the full 10 percent. This is the way Medair allocates the HQ costs to the projects. The total project costs consist of the direct costs and the 10 percent above the direct costs. The 10 percent is paid to HQ to cover the costs there. Sometimes the expatriates in the field also have problems with understanding the 10 percent. They feel like cutting the project budget with 10 percent, but actually the 10 percent payment to HQ is used for covering the running costs. That means that the field staff does not owe HQ money, but the 10 percent is used for the running costs of all projects. For Medair direct costs are all costs occurred in a project including HQ staff evaluation visits. All other costs are indirect costs. According to Medair, most of the donors do not want to pay the 10 percent used for indirect costs.
However, the 10 percent income has to cover the necessary costs to support and coordinate the different projects. Those are actually running costs for the projects;
although the 10 percent does not cover the HQ costs anymore. The costs of HQ are nowadays around 14 percent of the project costs. Even though they are charging 10 percent to the field, there is still a gap of 4 percent that has to be covered.
costs in CHF 2000 2001 2002
Project total costs
15,571,961 17,042,137 13,970,472
10 % charge
1,628,425 2,044,153 1,218,826
Project direct costs 13,943,536 14,997,984 12,751,646
Swiss admin 1,993,004 2,488,824 2,153,322
Total costs
15,936,540 17,486,808 14,904,968
Indirect/direct % 12.5 % 14.2 % 14.4 %
Table 3.1 Medair’s indirect cost %
The total costs consist of the project direct cost and the Swiss administration costs. To
know the project direct costs the 10 percent charge has to be taken off the project total
costs. The actual percentage is the Swiss administration costs divided with the total
costs. In figure 3.3, you will see the total cost graphically split up into project direct costs
(series1) and Swiss administration costs (series2). Year 1 is year 2000, year 2 is 2001 and
year 3 is 2002.
0 5000000 10000000 15000000 20000000
amount CHF
1 2 3
year
Total costs of Medair
Series2 Series1
Figure 3.3 Total costs of Medair
In the implementation phase, cost control is important. The project manager is fully responsible for the execution of the project. Every month HQ receives the monthly expenses from the projects and the responsible Finance Officer makes a Budget versus Actual expenses (BvA) report. This process is shown in figure 3.4. After the review between Operations and Finance, this report will be submitted to the project manager. In the actual project expenses, 10 percent is taken to cover HQ costs. The BvA is used to calculate and modify spending on the project for the remaining period, so that the budget limit is not breached.
Figure 3.4 the budgetary control process5
In the fifth phase, Evaluation, the final report is made and sent to the donors. Part of the final report is the financial chapter. In this phase, analysis is done to see where the surplus or shortages of money come from in relation to the project budget and how the budgeting and monitoring process can be improved.
5 Drury (1996, p.503)
Project
The Project Budget Monthly actual
project expenses
Monthly comparison Budget vs. Actual results
FEEDBACK FEEDBACK
§ 3.2.1 Information users
Who needs information about the indirect costs? What will they do with it?
The Governmental and International Donors want only to pay for a part of HQ costs or only for the project itself. Before funding a project, the donor wants to receive the project proposal with a well-defined project budget and narrative. They are not interested in the HQ costs and how these are spread over the different departments.
After the project, they want to receive a final report including a final financial report in detail. They acquire a budget versus the actual expenses and an analysis of under/overspending per budget line. They are interested in how the money has been spent at project site and if the project goals have been reached.
Donors do not want detailed information about HQ costs. They care about the project costs and mostly they give a lump sum for covering the HQ costs. How this lump sum will be used, they are not interested and Medair does not have to justify it. It is not their priority to focus on those costs.
The MT, BoT and StratCom are much more interested to know the HQ costs and to know if every department uses the money efficiently and effectively. At the beginning of the year the Finance Director together with the MT, make a budget for every HQ department. Every month the actual expenses are compared with the budget and if necessary corrective actions are undertaken; figure 3.4 also reflects this process. The MT needs to know all costs for making decisions and operational control and monitoring; for example to decide if a new project can be started. Most of the donors give 50-80 percent of the money when the project starts, the rest will come after finishing and reviewing the final report. In between Medair spent already the remaining part and so they have to use their own money for it. This means that if they have many projects in the same phase, they have to have a large reserve available to cover the last months of the project and also the HQ costs. They have to make estimations if this is possible, because it will give extra financial risks.
§ 3.3 Central research goal
Medair is supporting and co-ordinating all the projects from one location to operate fast,
effective and efficient. The projects are in large part funded by Governmental,
International and Institutional Private donors. But HQ is not funded by a donor. The
costs from HQ have to be allocated to the different projects. The projects will carry all
the costs. Every project is using HQ services, so HQ costs should be split over the
different projects. Until now, Medair uses the simplified method for allocation; 10
percent of the direct costs are taken as indirect costs to cover HQ services. The 10 percent
is included in the budget, but most of the donors do not agree with this. And why do
they not want to pay for this? Without a central organ, there are no projects at all. The 10
percent Medair is charging to cover the HQ costs is not sufficient anymore. This leads to
the goal of this research.
“The goal for this research is to analyze the indirect cost allocation method for Medair and compare it with the theoretical indirect cost allocation methods to find the best possible allocation method for Medair considering the donor restrictions for the indirect costs.”
§ 3.3.1 Central research question
The research central question is the translation of the original problem into a more tangible starting-point. The central research question is the question formulated that must be answered to solve the problem and fulfill the objectives.
Based on the problem background and the central goal of the paper, the central research question can be stated as:
“What is the best possible indirect cost allocation Method for Medair and how can it be applied?”
In order to get the best possible method, the costs of using the method should not overcome the revenues.
According to de Leeuw (1996) the content of the problem:
•
should be relevant;
•
should be possible to research the problem;
•
should lead to attaining the goal that had been set.
The first requirement, relevant, means that the outcome of the research meets the needs of the knowledge. Medair charges a 10 percent of the direct costs as indirect costs. This percentage does not correspond to the real indirect costs anymore as stated above. This means that there is a gap between the charged costs and the real costs. They need to re- evaluate their method and maybe change it. This shows that the research is relevant for Medair.
The second requirement is about the possibility to research the problem. This means that the central research question can be researched. Indeed this is possible through doing a literature review and researching the donor restrictions.
The last requirement is about efficiency and functional research. The research will be done within a minimum of costs. To get a more functional research limits have to be set.
The research is limited to Medair HQ. It should be executed within approximately seven months, starting from March 2003.
§ 3.3.2 Sub-questions and collecting data
The central research question will be split into concrete sub-questions. This is done to get a clear structure in answering the central question. The sub-questions are:
1. Which theoretical methods are there for allocating indirect costs?
2. What are the donor restrictions for Medair concentrated on the use of the indirect cost
methods?
3. How can it be applied to Medair in relation to the donor restrictions?
According to Baarda and de Goede (1998) there are three methods for collecting data in order to answer these questions: interviews, observations and existed data. Existed data has the preference, because the costs of collecting are low and you do not need to bother busy people to get the information you need. If existed data is not sufficient to answer the questions, interviews or observations will be necessary to gather the information needed to do the research. Interviews will mostly be done when knowledge, attitudes or opinions are necessary for the research.
According to De Leeuw (1996), there can be six information sources distinguished:
documents (in libraries, archives etc.), media (newspapers, magazines, radio, television etc.), reality (interviews, inquiries) ‘imitated’ reality (mostly in laboratory, also possible is computer simulations and experiments), data banks (e.g. CBS) and experience of researchers. Choosing the right sources is important because it supports the quality and efficiency of the research.
The methods Baarda and de Goede distinguish are broader than De Leeuw’s. The methods can be refined into the 6 information sources:
Baarda and de Goede De Leeuw
Interviews Reality
Observations ‘Imitated’ reality
Existed Data Documents
Media
Data Banks
Experiences from other researchers
Figure 3.5 Information sources
To know Medair as organization information will be collected through reading the Medair Handbook, the Quality Manual and other documents available like the annual reports, Medair brochure and so on. Moreover, to get a clear picture of Medair, their vision and their history the book written by Josiane Volkmar-André about the history of Medair is a very useful resource. These documents and books will give a clear picture of how Medair started, how they grew to the nowadays organization and all procedures used inside Medair. Especially the Quality Manual contains much information about documents and procedures used at HQ and also used at field level. The Quality Manual is a huge resource to understand Medair as an organization. It describes how things will be done and it encompasses all Medair guidelines. Every chapter, there are twelve, is divided into three categories: policy and strategy, formats and instructions, and annexes.
The policy and strategy describes why they do things the way they do. It contains the prerequisites, conditions or guiding principles Medair has defined on a certain subject.
The formats and instructions describe how they do things. It contains the Medair
guidelines, formats and instructions. The annexes contain examples and specific country
information. The focus for the chapters will be on the overall and HQ structure as well
as on the HQ departments and project management.
Furthermore, a better understanding will be gained how Medair works and how important finance is, through working as a finance officer and through attaining the Relief/Rehabilitation Orientation Course. The Relief/Rehabilitation Orientation Course will give a good background of Medair as organization and to get an understanding of working in the field. The training provided there is to be understood as an introduction to Medair and humanitarian work.
The information about the financial systems and procedures will be obtained through practicing and working with the two systems Globe Exact and AccountSafe. This experience will be attained through supporting the field operations by reviewing budgets, preparing the monthly budget versus actual expenses and so on. AccountSafe is used by the field teams to book their cash transactions. Medair HQ uses Globe Exact for bookkeeping. By supporting the field teams, a better understanding of the financial procedures and financial management inside Medair and their needs will be obtained.
Another technique to gather information in order to analyze Medair is to interview people. The goals for the interviews will be twofold:
- to get specific information what Medair needs and what their expectations are for this research;
- and to get specific information about the cost assigning at the moment and their problems with it. The following questions are important for this research:
•
What are the different cost categories and how have these been applied?
•
How does Medair define direct costs?
•
How does Medair define indirect costs?
•
What is the cost object according to Medair?
•
How does Medair assign the total costs to the cost object?
•
What are the problems with the cost assigning and how did this occur?
•
Who needs the information about the cost assigning?
•
What will they do with the cost information?
The interviews will be held with the finance director. These interviews or inquiries will often be ad hoc, open and not structured. During the interviews, the answers will be summarized and used as feedback in order to get the right picture and to have reliable information. Often the inquiries will occur at moments when the questions arise instead of having clear appointments.
In addition, discussions will be held with colleagues from different departments and with some field staff. Those discussions will give feedback for the research. These people will look at the matter from different perspectives and it will be fruitful to receive their feedback and comments.
In order to answer the first question the emphasis will be on collecting and summarizing
existed data. I will go to the library to get documents, books and articles, management
and cost accounting with the focus on indirect cost allocation methods. I will use books
written by Drury, Horngren et al, and Atkinson et al. Furthermore, I will search on the
internet for articles about traditional methods and Activity Based Costing. After
collecting the data, I will read them all and summarize the chapters and articles. This
information will be used to write chapter 4, about the theoretical indirect cost allocation
methods. I will make a structure how to write this chapter and sort out the summarized documents I can use for every part. For every part, I will summarize again the information and use this as background for writing Chapter 4.
For the second sub-question, I will use internal documents like the donor contracts and other internal donor information. Furthermore, I will use internet for doing research at the Governmental and International Donors and their requirements and restrictions. I will use the internet to search for additional or up-dated information. When I have collected the information, I will read them all through and highlight the information that is important for my research. I will do this per Donor. This information will be the base for chapter 5.
After having gathered information about Medair’s cost allocation method, theoretical procedures and donor requirements I will analyze and combine all gathered information and give recommendations to Medair what the best possible solution will be and work that solution out. In order to answer this question I need the information from the question above to get a clear overview of methods used and allowed to use. I will analyze Medair’s cost allocation method with the theoretical methods. After analyzing, I will work the best possible method out with the donor requirements and restrictions as my delimitations.
§ 3.3.3 Conceptual Model
A conceptual model gives an abstract overview of the different steps in order to reach
the central goal of this paper. According to Verschuren (1995) a conceptual model is a
schematic overview of the central thesis goal and it reflects the steps to take to fulfill the
central research goal in a structural way.
The donor restrictions influence the way Medair allocates the indirect costs. These requirements can be seen as constraints. Medair has chosen a certain method for allocating those costs, but this method is not covering the total amount of indirect costs anymore. Therefore, their method will be analyzed with the theoretical methods. The analysis will give insight in which way Medair can improve their method or maybe has to change their method. This will end in recommendations given to Medair.
§ 3.4 Research Definition
§ 3.4.1 Definition
The research for Medair can be typified as ‘policy supporting research’. According to De Leeuw (1996), this kind of research provides useful knowledge for the policy inside organizations. The goal of this strategy is to give knowledge that is useful in specific situations and that also satisfies part of the total need for knowledge. Knowledge about the indirect cost allocation methods will be given in this paper. Chapter 4 reflects the
Figure 3.5 Conceptual Model
Theoretical methods for indirect cost
allocation
Donor Restrictions
Medair’s indirect cost allocation method
Recommendations to
Medair
Analysis
possible theoretical methods supported by examples. The donors give restrictions for the method allowed to use and also for a fixed percentage to cover the HQ costs. In combination with the theoretical methods, this paper will give recommendations to improve the allocation for Medair.
According to Verschuren (1995), this research can be seen as a ‘desk-research’. It means that most part of the research will be done behind the desk, in the library or in archives.
Existed data will mostly be used. Interviews will be used to know what Medair’s expectations are, to find out the background of the research and the background of Medair. But most of the research will be based on existed data.
§ 3.4.2 Quality
Two indicators can measure the quality of a research: the ‘relevance’ and ‘reliable’
indicator (de Leeuw, 1996).
According to de Leeuw (1996), the relevance indicator can be split into three indicators:
•
Comprehensible; comprehensible means that the client understands the research and results. The presentation of the research results has to fit into the language and the way of thinking of Medair. This paper will be written in the language of the people who need the research. It will be as simple as possible without being unreliable.
•
Available in time; the research is only relevant if the results are available in time. If it is not in time, probably the results will not relate to the situation during the research.
•
Link with operating problems of the client; is the client really interested in the results and is the organization influenced by the results? Medair, the client, asked for the research, this implies they are interested in the results.
The reliable indicator can be divided into three criteria:
•
Correctness; a research is reliable if it is correct and right. This means that all that is written has to be true. Uncertainty or untruths provide an unreliable research.
•
Accuracy; accuracy means that results of the research fit into the client’s case.
•
Consistency; also the research should be consistent. All statements should be
consistent in order to be reliable and solid.
CHAPTER 4 Indirect Cost Allocation Methods
The focus in this chapter will be on the theoretical cost allocation methods. In order to produce products or services, organizations create costs. Part of these costs can be directly traced to the final product or service because of a clear relationship between them. The other part of the costs does not have a traceable relationship like for example the electricity costs, director’s salary, telephone bills and so on. Without those costs, the final object cannot be created. How should these costs be allocated to the final object?
Cost allocation is part of cost assignment. The difference between allocation and assignment lies in the two categories of costs, namely direct costs and indirect costs.
Why is it actually necessary to assign costs to a cost object? And what kind of methods are there to do this? This chapter will give answers to these questions.
§4.1 Cost Allocation
What is cost allocation? Before answering this question, the difference between direct and indirect cost must be explained. The distinction between direct and indirect cost depends on the cost object. Horngren et al. (1999) defines a cost object as anything for which a separate measurement of costs is desired. A cost object is the entity that ‘carries the costs’. This can be a product, a service, an activity, a department, a project, a country, a program et cetera. Direct costs can be directly traced to and identified with the cost object. These costs are costs that are related to the particular cost object and that can be traced to it in an economically feasible, cost-effective way (Horngren et al., 1999). So direct costs are clearly and easily attributable to a specific product, program, project, country et cetera; this is called cost tracing.
On the other hand, indirect costs are costs that are related to the particular cost object, but cannot be traced to it in an economically feasible and cost-effective way (Horngren et al., 1999). These costs are necessary for the operation of the project, but cannot be easily identifiable with a specific project. The indirect costs are shared among the cost object using a cost allocation method for splitting the costs. Instead of indirect costs also the term
‘overheads’ is used. In this paper both terms will have the same meaning.
Cost tracing and cost allocation together is cost assignment. Horngren et al. (1999) draw
the figure below to give a better understanding of the relationship between direct and
indirect cost and between cost tracing and cost allocation.
Figure 4.1 Cost assignment (Horngren et al., 1999)
Why should we allocate indirect costs to the cost object? What is the purpose of it? The full cost of a cost object includes also a share of the overall costs of the organization. This gives a total picture of the costs of a cost object. One of the purposes (Horngren et al., 1999) is to provide information for economic decisions. It is related to the planning of the future of the object. Another purpose is to motivate managers and employees. If they have an idea of the total costs of the cost object, they can try to find ways to lower these costs. Although some costs are out of their control like the adversaries mention (see the previous chapter). Maybe they cannot control the total costs, but a part of it. If they are responsible, they will use the sources in an efficient way. Furthermore, they have to control the costs to justify these or to calculate the reimbursement. This control can lead to corrective actions by comparing the actual costs with the budgeted. A last purpose is to measure income and assets for reporting to external parties, to communicate to external parties what the actual costs are to run the project, or to create a product.
It is hardly possible to attach indirect costs accurately to the cost object. Indirect costs are incurred for the benefit of all cost objects and the amount of indirect costs that should be allocated to a specific cost object can only be estimation. That is the reason why there are several methods for doing this. Some methods are very simple and easy to use, but less accurate, while others are more accurate, but more expensive to use. Which method an organization should use, depends on the purpose of knowing the costs of the cost object.
The next section will focus on the allocation methods.
§4.2 Cost allocation methods
There are different methods to allocate indirect costs to cost objects. In order to choose the one that fits best to the organization, the costs of using the method will be weighed up to the benefits for the organization. The costs of a method should not increase the benefits.
Direct costs
Indirect costs
Cost object
Cost tracingCost allocation
