Functional Expense Allocation
The allocation of expenses tells the story of how the organization spent its funding and what expenses went toward mission fulfillment. Given the importance of this information, particularly in how people perceive your organization, it is a critical part of the accounting function.
Nonprofit organizations are required to report functional expenses either in footnotes, the Statement of Activities (SOA), or a separate Statement of Functional Expenses (SOFE). Financial statement disclosures should also include a description of the methods used to allocate costs among program and support functions.
The goal of expense allocation is to illustrate the relationship between program expenses and supporting expenses to better understand how those supporting expenses further the organization’s mission. And while this sounds easy enough in concept, some expenses can be difficult to classify.
To complicate matters, functional expense classifications can change over time. Like a for-profit business, a nonprofit’s operations can change year-over-year, requiring that functional expense allocations be regularly updated to keep up with current activities. Otherwise, expenses can be misrepresented or fall through the cracks, resulting in misrepresentation of the organization to key stakeholders like grantors, donors, and boards of governors. Management also relies on functional expense information accuracy for strategic planning, making it critical to the day-to-day operation of the organization.
You should review your allocation methodologies on a frequent basis and ensure they are reasonable and consistently applied. For example, when allocating salaries and related benefits, employee timesheets may be a useful tool. In addition, when allocating occupancy expenses, you might utilize square footage by department or program.
While some organizations may intentionally try to limit their reported functional expenses to downplay the costs of running the organization, many others simply struggle with understanding what should be classified as a program expense or supporting service expense.
So, what should be counted as a functional expense? Nonprofit functional expenses generally include:
Program Services Expenses
Program expenses are those that are incurred to meet the mission of the organization, through programs or services, either directly or indirectly. The types of program expenses that a nonprofit has can vary greatly depending on the types of programs or services that the organization provides.
Most of a nonprofit’s functional expenses will be program expenses, or at least they should be. Donors typically prefer to support organizations that use most of their funds to provide programs to the communities they support. The only exception would be newly started nonprofits, which may not yet have the full extent of their programs up and running, limiting their associated expenses in the early days of the organization.
Management & General (M&G) Expenses
M&G expenses (also known as “general and administrative expenses”) are expenses that do not relate specifically to a particular program. Instead, they are related to the direction of the entire organization and its day-to-day operations. Usually, these expenses are related to management, accounting, IT, human resources, and governance. Examples would include:
- Accounting and financial reporting
- Audit and financial advisory services
- IT security
- Human resource management
- Advertising costs
- Insurance
Fundraising Expenses
Fundraising expenses are typically the easiest to classify because they are expenses that are directly incurred as part of obtaining donations. Donations can include monetary donations as well as donations of goods, time, services, or other assets.
Fundraising expenses include the salaries of employees who are dedicated to fundraising efforts as well as the efforts themselves, such as:
- Planning and hosting fundraising events
- Sending direct mail campaigns
- Recruiting volunteers at local events
- Distributing fundraising materials
- Connecting with donors
- Staffing donation drop-off locations
Remember, any staff that is working with potential donors, even if it is only in a limited capacity, should have a portion of their salary expense allocated to fundraising expenses. This is an especially salient point to keep in mind because an employee may spend time acting in this capacity even if it is not expressly included in the job description for their role. Rely on your financial leadership to determine how best to assign these expenses in accordance with your chosen allocation method.
Joint Costs
In instances where an activity fulfills multiple purposes, the expense must be shared between each proportionally. According to the Association of International Certified Public Accountants, joint costs can be allocated using methods based on:
- Physical Units – allocating costs based on output units
- Relative Direct Costs – allocating costs by using their respective direct costs
- Standalone Costs – allocating joint costs using an estimate of what each cost would be separately
Joint expenses are one area that regularly trip up nonprofit bookkeepers and accountants, requiring additional oversight from financial management to maintain accuracy.
Expense Allocation May Determine How Your Organization is Perceived
For many years the overhead ratio of nonprofits was used as a measure of efficiency and organizations that spent the least on overhead have been seen as the most effective. Jason Coupet, an assistant professor of Public Administration at North Carolina State University, argues that “although the overhead ratio might measure top-heaviness, it does not measure nonprofit efficiency.” In fact, his study found that lower overhead rates do not equate to efficiency. In fact, the exact opposite is true—they correlate negatively. (See also Transparency is Crucial in the November 2022 newsletter.)
The study gathered data from 666 Habitat for Humanity affiliates around the country and assesses efficiency using two different tools, looking at overhead ratio against number of houses produced. Both tools produced a finding of a negative correlation demonstrating that not only is the overhead ratio bad at assessing efficiency, but also that using it to assess efficiency may actively mislead donors.
The rise of the pervasive narrative that “overhead is waste” seemed to start down a more extreme path with the growth of charity rating services like GuideStar, Charity Navigator, and the BBB Wise Giving Alliance more than a decade ago. Despite many efforts to generate a more reasoned dialogue, there is a continuing and powerful mindset that charities are routinely “wasting money on overhead.”
Perhaps most frustrating of all, the ratings services that opened this Pandora’s box don’t seem to have made much progress in reversing the negative attitudes created by overhead mythology. This, despite the three rating services mentioned above having taken already the extreme step—perhaps even counter to their own financial interests—of directly addressing the “overhead myth” in a historic letter:
When we focus solely or predominantly on overhead, we can create what the Stanford Social Innovation Review has called The Nonprofit Starvation Cycle. We starve charities of the freedom they need to best serve the people and communities they are trying to serve. That letter was more than five years ago, and their “we take it back” effort clearly didn’t work.
The focus on overhead has been a significant thorn in the side of the nonprofit sector for more than a generation. The idea that nonprofits can be measured for their effectiveness using the proxy of frugality is deeply ingrained in public attitudes. The pressure to reduce (or “report differently”) on expenditures is both frustrating and discouraging to nonprofits. Remember this bias as your organization allocates expenses, even as sector leaders promote transparency and sustainability instead of manipulation and scarcity.
While nonprofit organizations exist to fulfill societal needs instead of generating profits, they still have complex financial needs. In fact, because nonprofit accounting differs so significantly from regular accounting practices, NPOs are in even greater need of strong financial leadership.
Learn more about all aspects of nonprofit accounting by attending the Sunshine Certificate in Nonprofit Management class on Accounting for Time & Money.
Click here for the yearly schedule to find the next class.
Sources: The NonProfit Times, Five Tips When Preparing Your Audit, on February 24th, 2022
The Nonprofit Times has been a preferred partner since 1996 when John Mcllagquhan, Publisher,was a keynote speaker at the Fifth Annual Nonprofit Conference. The NonProfit Times has published information about the Florida Association of Nonprofits in its monthly national publication.
CFO Selections Team, Understanding Nonprofit Functional Expense Allocation, on May 13, 2021
Nonprofit Quarterly – About Nonprofit Waste, Overhead, and Financial Subservience. Nonprofit Quarterly (NPQ) supports independent journalism and knowledge creation for civil society. They have been a trusted source for Florida Nonprofits since 2005. Sign up for Nonprofit Quarterly’s free newsletters to have their top stories delivered directly to your inbox.