Not-For-Profit Functional Expense Allocation Refresher

Whether you just closed your June fiscal year-end or are performing month-end analysis, it’s never a bad time to revisit your organization’s functional expense allocation.  But why would an organization need to revisit or review its functional expense allocation, once established?  The answer: any significant changes in the entity’s operations and activities including change in employee headcount, change in the organization’s programs, change in leases of facility and/or office space, change in mission, change in focus and time spent on various activities in a given fiscal period, to name a few, can trigger a need to update an organization’s allocation methodology.

Before we get too far, though, it may be helpful to revisit why the allocation is being performed and what it is being used for.  If a not-for-profit (NFP) organization obtains audited financial statements, there is a requirement to present information about total expenses in one location, either on the face of the statement of activities, in a separate financial statement such as the statement of functional expenses, or as a schedule in the notes to financial statements.  Those who do not obtain audited financial statements are still required to provide a statement of functional expense within Federal Form 990.  These disclosures tell an important story about how each organization uses its resources, allowing donors, creditors, and others to assess each organization’s use of funds and how grants and donations received are spent, whether on program services that further the organization’s mission or on supporting activities such as fundraising or management and other general activities.

The disclosures include detail regarding the natural expense allocation, describing the nature of economic benefits received (e.g. salaries and wages, employee benefits, professional services, supplies, rent, utilities, etc.), as well as the functional expense allocation, including program services and supporting activities (i.e. management and general, fundraising, and/or membership and development activities).  For both natural and functional classifications, any number of categories can be used, and each organization has latitude as to how it defines, aggregates, and lists the classifications, but appropriate classification often requires an allocation of expense for each benefited function.

Direct expenses, where costs can easily be identified as related to a single function (e.g. program, fundraising, or management and general expenses) is the preferred method and should be used when present.  However, many expenses relate to more than one program or more than one functional area and, thus, an expense allocation is required.  For instance, a leased facility may be used for business management and oversight, running programs that fulfill a mission statement, and activities to solicit contributions and grants.  As such, lease expense, a natural classification, should be allocated across functional categories in a rational and systematic way that is both reasonable and consistently applied.

The functional allocation of expense may be needed for many natural expense classifications and, because the nature of each expense may be different, the method used to allocate specific expense to each function may be measured differently. The most common allocation methodologies include an assessment of employee time spent in each function or an assessment of facility square footage used by each function.  By way of example, employees may perform activities in various functions.  In such instances, it would be reasonable to estimate the total number of hours each employee worked within each function and then calculate the estimated percentage of time spent in each functional area to allocate total salary and wage expense.  Similarly, an organization may estimate the square footage of office space utilized for programs, fundraising efforts, and/or management and administrative functions as a reasonable way to allocate total utility expenses incurred at the facility.  The important thing, here, is that the allocation base used is reasonable in relation to the nature of the expense and that the allocation methodology is consistently used unless the change in the methodology can be substantiated by changes in the entity’s operations and activities.

Here’s why it’s important to regularly review and reassess the functional expense allocation methodology.  No organization stays the same for any given period of time and any material changes should be evaluated to determine the impact on the allocation methodology.  For instance, consider the allocation of salaries and wages using employee time.  Employees may spend more time fundraising in a given year but spend more time providing program services in another year depending on the entity’s operational changes and objectives.  If the organization continues to use prior year estimated employee time percentages for its current year allocation, the methodology, while consistent, is no longer reasonable and should be adjusted.  Even if each employee’s time is dedicated to performing activities within a specific function each year, it may not be reasonable to allocate total salaries and wages to the organization’s functions using a prior period allocation percentage in instances where employee headcount has changed.  In this scenario, it’s possible that employees spending their entire time in programs have been terminated while employees spending their entire time in fundraising have been hired.  Again, the use of employee time would be consistent year-over-year, but the percentages used for the allocation of functional expenses would no longer be reasonable and would require adjustment.

Employee time and headcount aren’t the only changes that impact an organization’s functional expense allocation.

• If square footage estimates are being used to allocate expenses to functional areas, a new facility lease or downsizing of office space would necessitate a new estimate of square footage used for each function, changing the allocation.
• New vendor expenses in a natural classification such as professional services may require an adjustment to the functional expense allocation, depending on what services were provided and which function the services should be associated with.
• Insurance expense may require a change in functional allocation methodology if new or amended insurance policies are put in place, such as obtaining officer insurance for members of management who operate purely in the management and administration function or obtaining new vehicle insurance for vehicles that are only used for program services.
• Repairs and maintenance expenses may be incurred for assets or a facility utilized in program services one year, but may be incurred for assets or a facility utilized for support services in another year.
• If an organization allocates depreciation expense based on the functional area in which each asset is used, the allocation of depreciation expense would be impacted by significant new asset purchases, asset disposals, or repurposing a specific asset from use in one function to another (e.g. printer that was previously only used to by development for fundraiser solicitations and donor acknowledgment letters is repurposed for use in financing and accounting that fall under the management and administrative function).

There are many other examples, but it is clear that periodic assessments are needed to ensure the organization’s functional expense allocations remain reasonable and is based on estimates reflecting the entity’s current activity. Please contact us if you have any questions regarding your organization’s functional expense allocation.

About the Author

Related Services

Related Industries