With more prospective donors looking at a not-for-profit’s performance, consider whether your expense allocations accurately tell the story of your organization.

Most charity watchdogs like the Better Business Bureau or Charity Navigator use expense allocations to rate an organization’s efficiency and performance. While expense allocations are required for the Internal Revenue Service Form 990, they also can be a useful management tool because they are one way to determine how the organization’s resources are being spent.

By Classification

From an accounting perspective, voluntary health and welfare organizations are required to present expenses by both function (e.g. program, management, fundraising) and nature (e.g. supplies, salaries, depreciation), typically in a statement of functional expenses. Other not-for-profit organizations are required to report total expenses by function in either the statement of activities or in the footnotes. However, all organizations are encouraged to report their expenses using both a functional and a natural classification.

Note that losses are not allocated in the same manner as expenses. To determine whether a line item is an expense requiring allocation, or a loss which is not allocated, consider the nature of the activity. If the line item is associated with an ongoing major or central operation of the organization, it is more likely to be an expense. If the line item is associated with a peripheral or incidental transaction, like the sale of fixed assets no longer used by the organization, it is more likely to be a loss and should not be allocated.

By Category

There are two broad expense allocation categories—program and support. Program expenses are costs associated with activities that fulfill the organization’s mission. There is no prescribed number of or names for the programs to which an organization should allocate its expenses. Each not-for-profit is free to report its programs based on the activities unique to that organization in a way that best reflects the organization’s activity. In some cases, only one program category is needed; in others, more may be preferred. Generally, an organization would not have a separate category for programs that comprise 10 percent or less of the organization’s total expenses.

Supporting expenses can be further categorized into fundraising, membership development, or management and general. Fundraising expenses are costs, including salaries, incurred in bringing in revenue through donations of money, securities, services, materials, facilities, other assets, or even time.

Membership development costs are incurred as an organization develops and maintains its membership base. When determining whether an expense should be considered membership or fundraising, the organization needs to consider whether the members receive any substantial benefits. If the member receives no tangible benefits despite paying dues, the related costs should be considered fundraising expenses.

Management and general expenses are costs not related to membership, fundraising, or program services. Examples include the cost of obtaining financing, budgeting, accounting, general recordkeeping, board expenses, and strategic planning.

By Allocation

It’s important to note that some costs may have multiple elements. For example, the executive director may participate in a program’s activities, be actively involved in fundraising and be responsible for preparing and setting budgets. In this case, the executive director’s salary and related expenses would be allocated across the program, fundraising, and management and general categories.

When considering how to allocate expenses, direct identification of a cost is always preferable. For example, the cost of transporting children to summer camp can be identified directly as a program cost. However, when a cost is not directly identified with one function like program or fundraising, allocation is necessary.

Multiple bases may be used for purposes of allocation. Not-for-profits are required to choose only a base that is reasonable and justifiable. The base must be consistently applied from year to year and the organization must review it periodically for reasonableness and to ensure the base is still the best reflection of the activity being allocated. Examples of commonly used bases for allocation include square footage, salary costs, head count, or even the consumption of supplies.

With some thought and careful consideration, expense allocations can be a useful way to tell the story of your organization’s activities and how your organization uses its resources.

Maxine G. Romano can be reached at Email or 215.441.4600.