The allocation of functional expenses continues to receive scrutiny from donors, board members, regulators (e.g. the Internal Revenue Service), watchdog groups (e.g. Charity Navigator and Guidestar) and the general public. Some governmental agencies have been modifying their audit protocols to focus on the cost allocations reported to them each year. Why the increased scrutiny? Governments are looking for justification for budget cuts by rationalizing that nonprofit organizations are not running as lean as they should. In addition, there have been some highly publicized examples of nonprofit organizations that have had to endure media criticism of both their executive compensation and their cost allocation methodologies.
Cost allocations are also important because when done accurately and consistently, they can provide a realistic picture of the total cost of different programs. This information becomes critically important as nonprofit organizations work to stretch reduced resources and determine whether they must discontinue certain programs. In addition, many nonprofit organizations are required to report reimbursable expenses annually on cost reports. How you report these expenses by functional program will have a direct impact on your bottom line and potentially impact fundraising decisions. Allocation methods also impact the percentages of program, management and fundraising that will appear on your Form 990 and other reports – numbers that potential donors use to judge your organization’s worthiness for their contributions.
Before a nonprofit organization can perform a functional allocation, it needs to understand the importance of reporting expenses on a functional basis. The answer has to do with the financial statement users. While management is generally concerned with natural classification of expenses (salary, office expense, travel, etc.), financial statements allow them to understand the relationship between an organization’s program expenses and its supporting expenses. This helps uncover the “why” question regarding an organization’s expenses. Too much program expense may mean an organization is under-investing in technology, personnel support and development, or financial planning and audit services. Too little program expense may mean an organization is not being as efficient as it should be.
Therefore, it is crucial that an organization’s policies and procedures around the allocation of functional expenses be formally documented in writing. The Internal Revenue Service will often ask for it as part of an audit.
Best practices and critical elements of a formal functional allocation plan include:
- Documenting the functional allocation plan in writing. It is important that the methodology for allocating expenses can be easily communicated to the organization’s governance board, the independent auditors, and financial statement users. By documenting the plan in writing, it is easier to understand and update, when needed.
- Identifying the type of expense transactions that are directly allocated to one of the functional categories, or that need to be allocated amongst several categories. Further, if there are multiple program service offerings, it is important to identify the type of expense transactions that are directly or indirectly allocated to each program. Accurate cost allocation between programs can be important for grant reporting purposes and for determining the overall success of a particular program.
- Maintaining timesheets for individuals whose responsibilities include tasks that fall into more than one functional category or program. The time sheets should approximate the amount of time in a given week (or month) that the individual spends on program type services, administrative services, and fundraising services. It is important that the individual maintaining the timesheets understand the definitions of the functional categories and the difference in programs. If an allocation of time is not practicable, which is often the case with rent, utilities, and other space related costs, allocating by square-footage is an acceptable alternative.
- Establishing a chart of accounts within the accounting system that can help facilitate the allocation process in an efficient manner without providing a burden to management at year-end.
- Remaining consistent with the functional and cost allocation plan. Special exceptions to the plan should be minimal.
- Reviewing the allocation methodology at least annually. It is not uncommon for the funding stream of nonprofit organizations to change or for there to be a change in the make-up or responsibility of personnel.
When assessing an organization’s program expenses against supporting service expenses, it is recommended that you compare your organization’s ratios with the ratios of similar organizations instead of expecting there is a “right” percentage that would be expected for all nonprofit organizations.
The recognition and allocation of supporting service costs is an important piece of a nonprofit organization’s cost structure. The ability to fund these costs can make the difference between a successful organization and an unsuccessful one. Understanding your organization’s total costs can also help you increase efficiency and distribute your organization’s resources in a way that maximizes your programmatic effort while maintaining a justified level of supporting services.