Functional Expense Allocations and the Case for Overhead

“Donate to my nonprofit because 95% of our money goes towards programs.”

“Don’t donate to their nonprofit because 25% of their money goes to administration.”

These are common phrases heard when talking about nonprofits and charitable giving. What you may not know is that these phrases are referencing functional expenses. Functional expenses refer to the classification of expenses between program, management and general and fundraising. Additional subsets of the three main categories could also be shown.

There is a perception that management and general costs are “bad;” however, they can be seen as a positive.

• Having a ‘healthy’ amount of overhead can show that the organization has the resources to effectively manage a grant or handle a donor’s request to ensure that funds are spent on a particular program or focus area.
• If you are properly tracking the overhead costs, you may be able to negotiate a higher indirect cost rate with grantors.
• Having almost all of your costs allocated to program may make an informed financial statement reader question if the cost allocations are incorrect or purposefully misleading; what else in the financial statements could be skewed?
• If you have too little in management and general and fundraising, that may show the board that additional funding needs to be allotted to accounting and development functions to alleviate burden on the staff or help to maintain smooth operations.

All 501(c)3 organizations are required to show the functional expense classifications in their IRS Form 990, which is public information through guidestar.org. Additionally, many nonprofits show the allocations in their financial statements. Under the new FASB ASU 2016-14 Non-Profit Financial Reporting and Disclosures, all nonprofits will be required to show expenses by their natural and functional categories in a formal statement of functional expenses or a footnote in a grid format. Significant emphasis will be placed on the footnote disclosures about how the allocations were comprised and allocated. The new standard also provides additional guidance on what falls into each category, that may be different from how you are classifying now.

Costs can be allocated directly or based on an indirect allocation. Direct costs are fairly simple to allocate. As an example, program staff salaries are program, legal fees are likely administration, and event costs are fundraising. Note that supervision of program staff by a CEO and tasks like preparing grant billings, while related to a program, are considered management and general for the financial statements.

The difficulty is allocating expenses that cross categories or relate to the organization as a whole. The two main ways of allocating such costs are time studies and square footage analysis.

1. A time study is a period spent recording where an employee spends their time. Staff should select a “normal” week and track the time spent on each activity. Initially, an organization may do a quarterly time study and then scale back to an annual study after a thorough analysis has been performed.
2. A square footage study should be utilized for occupancy and overhead related items. Unless there are changes to the size or utilization of space, the square footage analysis can be utilized year after year. It is important to document your considerations of allocations, not only for footnote disclosure purposes but also as a potential audit consideration.

Properly stating the functional allocations is extremely important. As mentioned, donors and grantors may be looking at the allocations when making funding decisions. It could also be used as a tool to make adjustments to the budget.

• Are we not spending enough on fundraising and adding costs to the category that could potentially lead to additional contribution revenue?
• Is there a program that has high costs but does not add value to the organization’s mission?

While nonprofits want to spend 100 percent of their time on their mission, it is important to remember that nonprofits are still businesses and have certain supporting service costs related to running the organization. To be a well-managed organization or fundraise for contributions, a certain level of non-program costs are incurred.

Additional information about functional expense allocations, including guidance under the new FASB guidelines, can be found in our whitepaper, Functional Expense Allocation for Nonprofits After FASB ASU 2016-14.