Functional Expense Allocation: How to Divide Expenses Among Nonprofit Functions
Nonprofit organizations are expected to devote a high percentage of their expenditures to accomplishing their stated mission. At the same time, however, nonprofits also need talented management and staff to administer operations and engage in effective fundraising.
The percentage of expenses devoted to mission-critical programs is a key factor considered by nonprofit rating agencies. This makes it critical for nonprofits to implement an effective functional expense allocation process to keep the public and press informed about how resources are being used to accomplish its mission.
Financial Accounting Standards Board (FASB) ASC Topic 958, Not-for-Profit Entities, requires nonprofits to present the relationship between functional (major classes of program services) and nonfunctional (salaries, rent, depreciation and other overhead) expenses. Information about all of these expenses must be reported in a separate financial statement, on the face of the statement of activities, or as a schedule in the notes to financial statements.
Primary Expense Classifications
FASB defines functional expense classification as “a method of grouping expenses according to the purpose for which costs are incurred.” The primary functional expense classifications for nonprofit organizations are:
- Program services — These are the activities that result in goods and services being delivered in accordance with the organization’s mission. These goods and services are the major purpose and output of the organization.
- Supporting activities — These are activities other than the delivery of program services. Supporting activities typically include membership development, fundraising, cost of sales and management and general activities (e.g., accounting, payroll, human resources).
According to the AICPA, direct identification of specific expenses (i.e., assigning expenses) is the preferred method for charging expenses to various functions. Expenses that can be tied to specific programs or supporting services should be assigned to those functions. For example, meals or travel expenses incurred while delivering program services should be assigned to those services.
Direct identification may not be possible or practical when expenses are associated with more than one program or activity. In this case, cost allocation is appropriate. Use a cost allocation methodology that is rational and systematic and results in reasonable allocation of costs. Then be sure to apply this methodology consistently over reporting periods that share similar facts and circumstances.
Optimize the Allocation Process
Here are five tips for optimizing your nonprofit’s functional expense allocation process:
- Choose the right expense allocation methodology. Generally accepted accounting principles (GAAP) require nonprofits to disclose the method used to allocate expenses among program services and support activities. Be sure to use a methodology that is justifiable and document your reasoning to help prepare required disclosures and avoid comments from auditors.
- Allocate sufficient costs to program services. Nonprofit organizations may fail to allocate sufficient costs to program services when employees spend time performing activities that are outside their normal job descriptions. For example, if HR or accounting staff are involved in delivering program services, some of their salaries should be allocated accordingly.
- Allocate sufficient salaries to fundraising. Many nonprofits allocate an insufficient part of staff salaries to fundraising activities. If employees spend any time courting existing or potential new donors, a corresponding proportion of their salaries should be allocated to supporting activities.
- Allocate joint costs accurately. Nonprofits often conduct activities, such as special events and direct mail campaigns, that have a shared programmatic and fundraising purpose. In this scenario, joint costs should be considered for allocation using the physical units, relative direct costs, or standalone allocation method.
- Verify that your allocation methodologies are being applied consistently. Also be sure to update your methodologies to reflect any changes in your organization’s cost structure, operating facts, or circumstances, such as office space added or divested, staff positions added or removed, or significant programs started or discontinued.
Functional expense allocation requires careful consideration and professional judgement. You should work closely with your accounting professionals to ensure accuracy and avoid potential misstatement.
Please contact us to discuss functional expense allocation in more detail.
Sidebar
Busting the “Overhead Myth”
Donors and the media have traditionally formed opinions about charities based on the ratios of expenses allocated to program services and supporting activities. This has led to the “overhead myth” that these ratios are the sole indicator of a charity’s financial performance and cost efficiency.
Fortunately, this myth is finally being busted. The major charity rating agencies have recommended that donors look at performance factors other than administrative and fundraising expense ratios. And in 2023, Charity Navigator removed the administrative expense ratio from its rating system.
