Nonprofit organizations are constantly under scrutiny as to how they allocate their functional expenses in their statement of activities. Unlike for-profit entities, nonprofits must provide a statement of activities in the financial statements about expenses reported by their functional classification in order to assist outside individuals (like donors and grantors) in evaluating the organization, its use of resources and cost of services1.
Functional classification can be reported into two areas:
Program services: activities that result in goods and services provided to beneficiaries, customers and members, which fulfill the mission of the organization
Supporting activities: all activities other than program services, which include management and general, membership development and fundraising activities
Nonprofits report these activities in a separate statement known as the “statement of functional expenses.” While only some nonprofits are required to provide a statement of functional expenses, like voluntary health and welfare organizations, all nonprofits are strongly encouraged to do so.
The statement of functional expenses details expenses by their natural classification, such as:
These expenses are listed in a matrix format and are meant to support the effectiveness of your organization’s spending and activities.
Potential donors, funding sources and regulators will use this information to evaluate the relationship between your organization’s program and supporting expenses, by examining key ratios like:
One of the best practices and critical elements of a functional allocation methodology is documenting your allocation plan in writing. This written plan helps your governance board, auditors and any other users of the financial statements understand your allocations. It is important that you know the type of expenses that are directly (or indirectly) allocated, as cost allocation can be important in terms of grant reporting and determining the success of a program.
One of the most popular methods of functional expense allocation uses time sheets to allocate expenses based on an employee’s use of time within the organization. In instances where allocation of time is not available or practical, you can allocate square footage, actual usage or percentage of direct costs.
Management and general expenses can include:
The majority of nonprofits have some type of fundraising expenses. These expenses may include:
The best ways to optimize the functional allocation is to be consistent with the allocation methodology, and be timely when updating your methodology with any changes in your cost structure, including:
Your organization should periodically evaluate your method of classification and contact a nonprofit accounting specialist if you determine overhaul is needed.
If you have questions on nonprofit functional allocation, contact us online or call 800.899.4623.
(1) Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 958-720-45-2