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Head Over Heels

Skip Navigation LinksThe Funding Reform Costing and Pricing Head Over Heels

In examining logic-drivers and reflecting on how important it is to build Costing Models and Budgets by reasonable logic, we are generally speaking about direct costs – those costs which can be identified as associated with a specific Activity. Whilst we may build some logic based on organisation-wide expense (i.e. a “top-down” wages cost estimate), those costs are still considered to be incurred “directly” by each Activity – they are not re-allocated costs from another Activity.

It is critical in building an accurate Costing Model that we consider the full cost of the Activity including indirect costs – those expenses that are incurred by the organisation centrally, that need to be shared across all Activities to ensure full cost recovery and organisation sustainability. We will refer to such centrally incurred expenditure as “core overhead”.

Before we get into the detail of recovery of core overhead, we should be clear that we consider core overhead to be net of any funding specifically provided to cover those costs. You may disagree, in which case it’s important you are able to justify that to funders who have access to your detail accounts, particularly if you are requesting short-term grant funding from the same funder that provides the core income.

It is reasonable to consider the arguments for recovering your core overhead in funded Activities. Being able to do so in a logical manner may mean a successful inclusion of those costs in a funding contract. Each organisation could no doubt present its own case, but here are three general reasons:

  • The capacity of an organisation to provide consistent quality services to its clients and stakeholders is premised upon its medium-to-long term sustainability and the associated stability that affords in retaining staff and maintaining facilities and other resources. If recovery of core overhead is not achieved, the very existence of an organisation will be in doubt and its capacity to provide services will be directly affected.
  • If an organisation cannot recover its core overhead via its funding agreements, it will need to do so via other means, i.e. other forms of revenue or reserves, which will mean redirection of resources away from operational areas and a reduced focus on quality service provision
  • An organisation that can recover its core overhead across a number of funding agreements represents an efficient form of investment by funders, as individual programs, particularly those of a short-term nature, will not need to incur start-up costs and one-off expenses for each project.
  • An organisation that can recover its core overhead across a number of funding agreements represents an efficient form of investment by funders, as individual programs, particularly those of a short-term nature, will not need to incur start-up costs and one-off expenses for each project.

Before we look at methods of cost recovery it is worth recalling that we suggested above that the core overhead area should form part of your Activity identification – e.g. core operations / general admin / corporate services etc. Being identified as a distinct Activity, core overhead should have its own set of logic-drivers and a Costing Model and/or Budget and most likely, a solid history of Actuals. Whatever method of recovery is eventually used, the degree of recovery of core overhead is directly linked to our capacity to accurately estimate it in the first place.

In determining the method for recovery of core overhead, we suggest two broad approaches:

The first approach reallocates a set amount of expense from the core overhead Activity into individual funded Activities. The recovery could be a set dollar amount or set percentage of the total estimated annual core overhead expense. This approach means the amount to be recovered is predetermined to reflect known funded Activities to be undertaken. As such, this first approach is more suited to a stable, predictable environment where funding agreements are longer term and Activities are predictable.

Simplified, this first approach would look like this:

Rather than reallocating expense, the second approach reallocates a portion of the income from the funded Activity back to core overhead. Rather than trying to recover a predetermined amount in total, this approach implies that each funded Activity must recover core overhead in proportion to its funding income. Often a percentage of funding is set as a benchmark or a cost per new employee – these are then used to build the initial Costing Model and to commence discussions with funding agencies. However it is calculated, the figure often has no direct reference to actual core overhead and is not meant to, but is considered within the bounds of what history suggests funders will accept.

This approach has inherent risk, in that it may be difficult to predict what funded Activities will come to fruition in any one period and as such, not all core overhead may be recovered. Nonetheless, the approach is widely used and generally suits organisations that have both ongoing and short-term funding agreements, preferably with cash reserves sufficient to cushion core overhead in times of volatile funding. It is also relevant for organisations that have a number of funding agreements falling due at varying times, to the extent that core overhead recovery becomes a “rolling” process across different financial periods, where the core overhead itself is also changing.

Simplified, the second approach would look like this:

You could of course reverse the allocation with the first example moving across income and the second across expense. What’s more important to recognise is that in both cases, funds are reallocated across income or across expense. It is not recommended to reallocate funds between income and expense, i.e. creating an expense in the funded Activity and an income in core overhead. We recognise this is common practice, however unfortunately it’s not good accounting practice. By way of explanation: those of you who have close friends in the audit fraternity may well have discussed this at dinner parties, but for the rest of us, we have to appreciate that auditors don’t like it when we artificially increase income or expenditure past that of real life transactions. Given that core overhead recovery is an internal accounting entry between Activities, if we reallocate funds between income and expense it has the effect of increasing both for the organisation as a whole; a big no-no in the wonderful world of audit – and understandably so.

While we’re rattling on a bit, another quick word on reality versus accounting, ask your accountant or bookkeeper whether they’ve done the entry for your program’s core overhead recovery and where it appears on your financial report. It’s not uncommon to see core overhead approved by funders, but then lost to the real world in a myriad of accounting entries. Indeed, such issues abound across NFP financial management, where the number crunching is considered some magical process which normal people couldn’t possibly understand. 

Before we move on to pricing, it would be remiss not to add some practical evaluation of core overhead recovery. We certainly recognise it is not as simple as calculating an amount and including it in funding applications. Nor do we assume funders will automatically accept that a set percentage of the funding should be allocated to core overhead recovery. Whatever approach organisations are using to calculate their core overhead recovery, they often show that recovery as a series of notional expenses in the funding application; say rent, utilities, property, ICT etc, in an attempt to identify why the recovery is relevant to the service deliverable. Seemingly very few are prepared to simply call it “core overhead recovery”.

All this is understandable and no one is expecting it to change any time soon - negotiations will and should take place; indeed the up-side of the new procurement regime is those negotiations should (in theory) take place in a more transparent and consistent manner – costs are costs and prices are prices. What we see as more important than a prescribed technique at this stage is that organisations develop their own clear and consistent methods of calculating core overhead recovery and include it in their funding applications - from that point-on negotiations should revolve around price/funding. We see no sense in including core overhead recovery in one application and excluding it from others, or indeed having a varying approach across different Activities. 

If an organisation chooses to lower the price of a service to absorb its core overhead then so be it, it’s another thing altogether to suggest some services incur core overhead and some don’t. We feel that if both funders and service providers recognise this up-front, a clearer path to sustainable pricing is more likely to appear. For now however, whilst funding remains relatively predetermined and short-term and funders take varying approaches to core overhead recovery, we will continue to ask ourselves “what comes first - the core overhead or the core overhead recovery?”

So, what’s the price then?

We mentioned at the outset that price should be an outcome of cost, i.e. decisions on the price of an Activity (let’s swap the term to “service” for this part) should reflect the costs of that Activity (service). This seems fair enough; so to help us through this process we’ll call on a fairly familiar term known as “margin”. For our purposes, the margin is the difference between the cost of a service and its price. The term still applies whether a unit $ cost or total $ cost is the basis of a funding application.We apply a Pricing Method to a particular service by asking ourselves what margin we would like to apply as a percentage of cost and to whether the margin is variable across a service. ‘Margin’ and ‘Pricing Method’ are not directly interchangeable in all cases; because we may choose to exclude some costs from the margin uplift, e.g. we may prefer to show funders we are not making a margin on core recovery. Further, certain service deliverables may be excluded from margin uplift. 

For now, let’s keep it simple: a positive margin implies we will retain a surplus of funds at the conclusion of the service agreement, a zero margin implies we will neither lose nor make money, and a negative margin implies the organisation will subsidise the delivery of the service from other sources, or other issues are at play, such as the Costing Model includes notional volunteer costs not included in the price. So what’s the right margin?

Before we get onto that, let’s consider what might be a good theoretical starting point. If we take a particularly commercial approach to the process, a back of the envelope calculation would suggest a “return on investment” (i.e. margin) should be at least equivalent to return on cash if the same amount of money was placed in a bank deposit, say 5%, plus say 3% for risk and sustainability, another 2% for asset replacement and finally let’s say 2% for a general contingency on costing. In theory then, if we got 12%+ margin we’d be travelling relatively well if we were in the commercial world. So is that the right margin?

Well, it’s a trick question, there is no “right” margin; there is simply the margin you are able to negotiate. We don’t operate in a commercial environment and are rarely given the opportunity to provide a simple price to deliver a prescribed service. Although it must be said that a particularly “commercial” procurement already exists in some areas of NFP service provision, in which case the “double-digit” margin isn’t the worst place to start if you’re in that game. Even then, the margin you’re prepared to accept will depend on the size of the organisation, cash reserves, the degree to which other services are absorbing core overhead, the mission of your organisation etc.

Dealing in the small-to-medium funding areas however, things are often more fluid. Funders offer opportunities to submit applications but it many cases ‘price’ forms part of the discussions only as far as it represents the predetermined amount of funds available to achieve specified service deliverables. In that regard it is often not a discussion about the price for a particular service, but the service for a particular price. This is important, because a good strong knowledge of cost, and the corresponding logic-drivers for a service (including core overhead recovery) will be a wonderful ally to anyone having to “cut their service cloth” to suit a predetermined price. 

A discussion as to whether costs can be reduced without directly effecting service provision is the same as a direct discussion about margin. If costs can’t be reduced, then an understanding of the degree of service reduction at varying funding levels is the next best thing. Many issues will come into play to varying degrees and all are dependent upon service type, the funding amount and the funding agency. Regardless, being able to model scenarios, or ‘what-ifs’, around varying logic-drivers and varying margins can seem complicated, but  an in-depth knowledge of the Costing Model for a particular service will go a long way to ensuring the best possible outcome.

One of the prudent checks-and-balances before final pricing is to revisit the service deliverables within a funding application and to ‘’map” those deliverables to expense areas in the Costing Model. This could be as straightforward as “deliverable A is mapped to employee A” or “Regional visits are mapped to Regional Travel expense”. In organisations where operational managers prepare the funding application and senior managers give final sign-off, this process of challenging the real-life aspects of the Costing Model before final pricing is an excellent way to share ownership of the Costing Model and give all parties confidence in its validity.  Pricing/funding variations can then be negotiated within the context of what degree individual deliverables will be affected by price change.



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