Not-for-profit organizations play a crucial role in advancing charitable causes. To operate effectively, these organizations must accurately allocate their functional expenses across different programs, activities, and support functions.
Allocating expenses appropriately ensures transparency, accountability, and potentially compliance with accounting standards. While there are specific guidelines provided by regulatory bodies, not-for-profit organizations often need to exercise judgment in determining the most suitable methods for expense allocation.
Organizations should try to be consistent from year to year in the methodology that they employ to allocate functional expenses. Consistency will improve comparability for the readers of the financial statements both internally (for developing budgets or financial planning) and externally (when applying for grants). Having a documented methodology will assist management and finance departments with understanding the allocation and with applying it to their financial statements.
Following are examples of three methods commonly employed to allocate functional expenses.
- Direct allocation. Direct allocation is a straightforward and widely used method of allocating functional expenses. Under this approach, expenses that can be directly attributed to a particular program or activity are allocated solely to that program. For example, if an organization holds a fundraising event, the costs associated with organizing and conducting the event would be allocated directly to the fundraising program. This method offers clarity and simplicity in expense allocation, as the link between expenses and programs is clear.
- Allocation based on usage. Allocation based on usage is a method that considers the extent to which different programs or activities utilize shared resources. For example, if an organization has a central office that provides administrative support to multiple programs, expenses such as rent, utilities, and office supplies can be allocated based on the percentage of time or space utilized by each program (in square footage or another metric). This approach ensures that expenses are allocated fairly, reflecting the relative usage of shared resources.
- Functional allocation. Functional allocation involves allocating expenses to various functional categories based on their nature. This method is particularly useful for organizations with distinct functional areas, such as program services, management and general administration, and fundraising. Expenses are allocated to these functional categories based on their primary purpose. For instance, expenses related to program delivery would be allocated to program services, while expenses related to board meetings and governance would be allocated to management and general administration.
Accurately allocating functional expenses is essential for not-for-profit organizations to demonstrate transparency, accountability, and compliance with accounting standards. While regulatory bodies provide guidelines, not-for-profit organizations often need to exercise judgment in determining the most suitable methods for expense allocation.
The methods discussed in this article offer flexibility and adaptability to diverse organizational structures and resource-sharing scenarios. By employing appropriate methods, not-for-profit organizations can ensure fair and reasonable allocations of expenses, thereby facilitating effective management and reporting of their financial activities.
If you have any questions or would like to discuss how your organization can effectively employ these methods, please contact Dan Bergvall, Manager, Audit & Accounting at Email or any member of our Not-for-Profit Industry team.
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Information contained in this alert should not be construed as the rendering of specific accounting, tax, or other advice. Material may become outdated and anyone using this should research and update to ensure accuracy. In no event will the publisher be liable for any damages, direct, indirect, or consequential, claimed to result from use of the material contained in this alert. Readers are encouraged to consult with their advisors before making any decisions.