The Function of Functional Expense Allocation
Originally published on October 11, 2023
“The devil is in the details.” It’s an old saying about hidden, mysterious aspects of a situation that could cause problems later. Yet it’s also a persuasive argument for functional expense allocation. Because not only is this practice required for compliance, it provides a more detailed picture of exactly where your nonprofit’s money is going.
The Basics of Functional Expense Allocation
In functional expense allocation, your nonprofit’s costs and expenses are distributed among different functional areas. The goal is to accurately assess the full cost of carrying out each function within your organization. This allocation is detailed in the statement of functional expenses portion of your financial statements.
In nonprofit accounting, expenses are generally classified into three main categories:
- Program Services: These are the costs directly related to fulfilling the organization’s mission. If your nonprofit focuses on education, for example, program services might include costs for teachers, materials and educational programs.
- General and Administrative: Also called “management and general,” these costs are not directly linked to program services but are necessary for the overall functioning and governance of your organization. This could include expenses like governance, administrative salaries, accounting services and general office supplies.
- Fundraising: These are costs associated with generating contributions or fundraising event revenue for the organization. They include activities like donor solicitation, hosting fundraising events and grant writing.
The IRS requires that you use all three functional expense categories. However, functional expense allocation breaks them down even further to provide a better picture of your costs. Your program services costs, for instance, can be subdivided as individual programs to show costs incurred to run each program separately (rather than combining all programs in one column).
Compliance and Transparency
For starters, it’s the law. Your statement of functional expenses must be submitted as part of your IRS Form 990. Additionally, your financial statements won’t be compliant with generally accepted accounting principles (GAAP) if you don’t present a functional expense allocation. So a clean audit opinion can’t be obtained without clearly stating this information.
Functional expense allocation can also play a vital role in securing donors. If your expenses are broken down more explicitly, it’s easier for an outside party to assess your statements. This is especially critical in the nonprofit world. Donors, grantors and regulatory agencies often want detailed reporting on how funds are spent and will compare statements of multiple organizations.
Allocating your costs in detail on your financial statements showcases how much of your funds go to program costs vs. administrative and other areas. This transparency isn’t lost on generous stakeholders looking for a cause to support, as they understandably want to see how their donated funds make a direct impact.
Budgeting and Strategy: The Secondary Benefit
Compliance and transparency are certainly important. Yet functional expense allocation provides an additional benefit. The more detail you have about where your organization’s money goes, the better you can understand the full cost of each of your operational areas.
This clarity helps you in budgeting, performance evaluation and strategic planning. For example, you can see whether a specific administrative function is taking up more of your expenditures than it should. It can also help with fraud detection. If your third largest program has the highest salary level, for instance, it could indicate payroll fraud. A program that doesn’t involve travel but shows a lot of travel expenses could be a sign of reimbursement fraud.
How do I implement functional expense allocation?
There are a few methodologies you can follow. Direct allocation directly attributes specific costs to a function. For example, the salary of a teacher would be allocated to “Program Services” in an educational nonprofit.
With indirect allocation, you use a reasonable basis (e.g., square footage, time spent, headcount) to allocate costs that benefit more than one function. Let’s say you have a building that houses both administrative offices and program services. The utility costs for that building might be allocated based on the square footage occupied by each. It’s important to look at each cost category individually to determine the appropriate allocation basis rather than applying one allocation basis across the board.
While some organizations stick with either direct and indirect exclusively, many choose a hybrid format that mixes allocation methods. Whichever you choose, your nonprofit needs to take two important steps to implement functional expense allocation.
Establish a cost allocation plan.
A written summary of how costs are classified makes it easy to allocate them as your money is spent. This is known as a cost allocation plan — and not only does it save time later, it’s also a requirement for most grants. Auditors will also review this plan to make sure you’re following necessary procedures. This makes it a critical tool in functional expense allocation.
Take the following steps to create your cost allocation plan.
- Determine your method of allocation (direct/indirect, etc.). There’s no one best option except for whatever best suits your nonprofit’s operations and abilities.
- Gather the necessary documents. This includes timesheets, building space measurements and programmatic reports.
- Establish a timeline on when the documents are submitted and how they’re reviewed and approved.
- Determine how often you’ll update your plan and how often you monitor it. This could be monthly, quarterly or when you see significant operational changes.
- Set realistic expectations. Consider outside factors that impact your cost allocation procedures – for example, vendor invoice schedules or seasonal work ebbs and flows. These might not always dovetail with your timing choices, so do your best to accommodate them.
Above all, keep the plan simple! Your staff should easily understand the steps and be able to run the calculations it requires. This also helps you better monitor financial operations; the more complex a plan, the more places for errors to hide.
Create a robust, detailed time entry system.
Your employees should have the option to classify their time by the nature of work performed. Let’s say your organization is a food pantry. A staff member, for example, distributes food (your essential mission). Yet they might also perform administrative tasks like stocking office supplies or running reports. Dividing their hours for these purposes clearly ties their salary to specific functions of your nonprofit.
Employing functional expense allocation year round makes it easier for your organization when audit time comes. It keeps you in compliance with requirements and provides clarity in your spending. It’s also crucial for management and your board to have this information on a regular basis (at least monthly). This ensures your nonprofit runs smoothly and detects issues in a timely manner.
If you don’t have functional expense allocation in place now, get started as soon as possible. We also recommend teaming up with a nonprofit CPA to look closely at your current accounting system and expenditures. They’ll help you find the appropriate classifications that best fit your nonprofit’s operations, staffing and capacities.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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