How to Properly Allocate Expenses in Your Nonprofit Financial Statements (and Why It Matters)
July 1, 2021 - Common sense tells us that every business needs to know how money is being spent in order to know if the business is truly profitable. Both efficiency and profitability matter to nonprofits as much as any business – and properly allocating expenses helps you sustain both.
Proper expense allocation is required by the IRS and guidelines set forth in GAAP (Generally Accepted Accounting Principles). But taking the time to do expense allocation right is also a smart business practice for nonprofits, with benefits to your organization both internally and externally. The good news is that once you’ve established a methodology for allocating expenses, the process for keeping it running will be that much easier.
Let's start with the ways proper allocation and categorization of expenses helps your nonprofit run more efficiently.
By properly allocating expenses, you will get a better understanding of the true costs of specific programs, which allows you to set appropriate funding (and fundraising) goals to help ensure program sustainability.
For example, a program with high costs may be worthwhile if the mission impact is also high, but you may need to generate additional revenue to cover it. With proper allocation, you can make better financial decisions and more effectively assess the cost-benefit of individual programs and fundraising efforts.
Meeting the IRS's expectations is only one way allocating your expenses properly can benefit your nonprofit from the outside. Donors, grantors, and other funding sources review financial information when deciding how to contribute (or whether to contribute at all). You’ll want to ensure your allocation methods are not inadvertently overstating management and general expense, while ensuring program costs are being fairly presented.
Expense Allocation Simplified
First, you’ll want to understand how GAAP defines program, management and general, and fundraising functions under ASU 958-720-45.
In general, program activities are associated with the activities that result in the organization’s mission being fulfilled, whether it’s providing goods or services to beneficiaries, customers or members.
Management and general activities relate to overall management and oversight of the organization and includes costs related to general recordkeeping, budgeting, business management and employee benefit management. Fundraising activities include those related to soliciting contributions, gifts or grants.
Next, you’ll need to analyze your expenses to determine which can be directly identifiable and associated with a specific function and which are shared direct costs that relate to multiple functions. Finally, you’ll need to determine the best methodology to allocate each expense.
Shared Direct Costs vs. Administrative Costs
Nonprofits must distinguish between administrative costs and shared direct costs in their accounting. The difference can be confusing, so here's a brief explainer:
- Administrative costs apply to the organization as a whole, so they are categorized as management and general. These are defined by GAAP standards and include oversight, day-to-day management, record-keeping, etc. From an auditing standpoint, neither management and general nor fundraising expenses can be allocated. So for external purposes (like oversight, management, payroll, etc.), administrative costs have to remain under management and general. However, allocating costs internally can give you a truer picture.
- Shared direct costs are expenses that relate to operating the organization itself and accomplishing the work at hand. These are resources that are shared by multiple programs but whose costs are not directly identifiable. Accounting standards define them more specifically, but they usually include things such as office space, payroll for staff who work on more than one program, utilities, technology and other equipment or office supplies.
Expenses of all kinds should be proportionately allocated to the programs they support in order to show true total program costs.
Various allocation methodologies can be used to allocate expenses that are not directly associated with a single function. To meet GAAP standards, the allocation methods you choose must be reasonable and consistently applied. To ensure your organization meets the consistent application requirement, we also recommend that you document your allocation methods.
You’ll need to evaluate which expenses need to be allocated and determine the allocation method that is the most sensible based upon the size and structure of your organization.
For example, expense could be allocated based upon:
- Square footage: Nonprofits can use square footage used to allocate costs like rent, utilities, insurance, building depreciation and property taxes.
- By estimated employee hours: If nonprofits are seeking reimbursement of payroll expenses under grants, it's important to have each employee document the actual amount of time spent on each function/grant area during every pay period. Organizations can use this information to not only allocate salaries expenses but also the related payroll taxes and employee benefits. Furthermore, employee hours can be used to estimate other expenses such as training, information technology and phone usage.
- Number of employees: For organizations without complex grant reporting requirements, allocating payroll, taxes and benefits based simply on headcount may be reasonable.
- By tracked usage: Office equipment like copiers typically code usage by department and staff member so it’s easy to allocate these costs accordingly.
Ultimately, you don’t need complex calculations and spreadsheets to allocate your expenses properly. In fact, the simplest system can often be the most reasonable. As long as your methods are justifiable and consistent, then you're meeting GAAP standards.
When setting up a system for allocating expenses, it's also important to gain buy-in from individuals who will be affected by these allocations. Everyone should feel comfortable with your financial processes and statements. You want the people running your programs to sign off on the budget method, and you want your CFO to be confident in getting support from the finance committee and the full board.
Lastly, your written policy should document assumptions and judgements you use to establish each allocation method. This ensures consistency and also demonstrates to donors and other external sources that there is a sound basis for your allocations.
Combatting the “Overhead Myth”
High management and general costs make nonprofits look bad due to a prevalent myth that says lower administrative costs equate to a better-run organization. That’s not necessarily true. In fact, a well-run organization must spend time on administrative costs like management, operating the organization, recordkeeping and more to function efficiently and effectively.
According to the Charities Review Council, program costs in a well-run nonprofit organization should account for 70 to 90 percent of total expenses. That’s a pretty wide range. It’s not meant to be a goal, but a benchmark to judge how your organization is doing. In reality, total program expenses will vary significantly depending on the nature of your organization.
For example, if your organization receives significant amounts of program funding that is essentially passed through to others with minimal administrative requirements, you probably have a very high percentage of program costs. Additionally, if your support comes mostly from individual contributions, then you probably have a high percentage of fundraising expenses.
Proper expense allocation enables you to present an honest financial picture to prospective funders, but it is also incumbent on every organization to help donors understand the “why” behind your expenses so your overhead doesn’t appear unreasonable. That's why we recommend that your note disclosures and 990 narratives are sufficient to clearly explain the nature of your organization as well as the methods used for expense allocation.
Educating donors and sponsors on your accounting methods and financial picture builds trust, confidence, and stronger relationships that can go a long way toward securing even greater support in the future.