The total cost of providing a target service in-house, also known as the fully allocated cost, is the sum of its direct costs plus a proportional share of organizational overhead, or indirect costs. When the direct and overhead costs of a target service are identified, the resulting dollar amount constitutes the "fully allocated cost," or total cost, of providing a target service in-house.
Direct Costs +
Share of Indirect Cost
= In-House Fully Allocated Cost
A. Direct Costs
Direct costs are those cost items that only benefit, and thus are totally (100%) chargeable to a target service. Examples of direct costs include the salaries, wages, and fringe benefits of government employees who work exclusively (100%) on the in-house delivery of a target service, as well as the costs of supplies, materials, travel, printing, rent, utilities, communications, and other costs consumed or expended for the exclusive benefit of a target service.
B. Direct Costs Frequently Overlooked
Some direct-cost items are routinely overlooked when computing the cost of providing a target service in-house and thus warrant special mention. Frequently overlooked cost items include: interest costs, pension costs, and facility and equipment costs.
Interest on capital items purchased for the exclusive (100%) use of a target service through a bond issue or other financing arrangement should be included as a direct cost of in-house service provision. For example, a fire truck purchase that is financed will typically take interest payments from a local government's general fund, but this cost should be counted toward the cost of fire-protection services. (Equipment costs are handled below.)
The pension costs of government employees who work exclusively (100%) on a target service should be included as a direct cost of in-house service provision regardless of whether the government fully funds the pension plan or not. Unfunded and under-funded pension plans defer, but do not avoid, these costs.
FACILITY AND CAPITAL EQUIPMENT COSTS
Facilities and capital equipment used exclusively (100%) for a target service should also be included as a direct cost of in-house service provision. Depreciation costs can be computed, or, if depreciation is not appropriate or no depreciation schedule exists, a use-allowance factor can be computed. (Use allowances are employed for those capital items for which no depreciation schedule exists. For most municipal items, depreciation is appropriate.) Even when no actual cost is incurred, a use allowance factor should still be included because the asset could be used for other government purposes or sold.
C. Overhead Costs
Overhead costs, or indirect costs, are cost items that benefit the target service and at least one other government service, program, or activity. The expenses of various administrative and support services provided to a target service by other governmental departments are overhead costs. Examples include: salaries, wages, fringe benefits, supplies and materials, travel, printing, rent, utilities, communications, and other costs that benefit the target service and at least one other government service, program, or activity. A check should also be made to ensure that overhead costs include applicable interest costs, pension costs, and depreciation or use-allowance costs on shared facilities and equipment. If not, these costs should be added to applicable overhead costs.
Overhead costs are generally apportioned among government services, programs and activities according to some allocation scheme. The most common methods are "personnel costs," "total direct costs" and the "step-down" method. The personnel-cost method assumes that overhead costs are proportional to the number of employees (or full-time equivalent employees). The total direct-cost method assumes overhead is proportional to the budget of the target service. And the step-down method divides all departments into either support or production departments, and works by allocating all the costs of support departments to the other entities they serve.
Many state and local governments have automated accounting systems capable of identifying, tracking, and allocating overhead costs. Frequently, state and local governments develop overhead or indirect cost rates that are simply applied to the personnel or total direct costs of a target service.