Cost Allocations - More Important than Ever for Nonprofits

March 20, 2020

Allocating costs has always been an important task for nonprofit organizations, and with the FASB’s Accounting Standard Update (ASU) 2016-14, Presentation of Financial Statements of Not-for-Profit Entities (Topic 958), it has become more important than ever.

In fact, providing financial statement users an analysis of expenses by both their functional and natural expense classification is required for all nonprofits in order for their financial statements to be in accordance with generally accepted accounting principles (GAAP). Additionally, the IRS requires nonprofits to present this information on their Form 990 and some funders of federal awards may also require nonprofits to allocate their costs. Therefore, it is essential for nonprofits to develop and maintain a cost allocation policy so that they can keep record of their allocation methodologies and ensure they are applied consistently. Not only does this keep the nonprofit compliant with the rules and regulations described above, but it also allows management to perform adequate business analysis, especially for organizations with multiple departments or programs.

There’s lots to consider when it comes to nonprofits. We recently compiled a list of nonprofit trends.

What Is Cost Allocation?
Cost allocation is the process of spreading shared expenses across significant program services and supporting activities, which are the functional classifications. This should include direct and indirect costs. Direct costs are just what they sound like—costs that are directly identifiable to a specific program or activity. Indirect costs are the just the opposite—costs incurred that benefit more than one objective and cannot be tied to one individual program or activity.

Each significant program or department of a nonprofit should have its own functional expense classification, which are all supported by supporting activities. These supporting activities include classifications such as:

  • Management and general
  • Fundraising
  • Membership development activities

In addition to allocating expenses based on these functional classifications, nonprofits must also disaggregate these functional expense classifications by their natural class. The natural expense classifications include classes such as salaries, legal fees, office expenses, and travel, just to name a few. Part IX of the IRS Form 990 is the statement of functional expenses section of the form and provides the natural expense classification detail that is required to be disclosed and submitted to the IRS.

This can be a good starting point for nonprofits when thinking about their own organization and natural classifications that are applicable to their programs and supporting activities, specifically for internal and other reporting purposes. More detailed natural expense classifications may be used for these purposes; however, the level of detail on the Form 990 is required for reporting requirements to the IRS.

Four Key Steps in the Cost Allocation Process
The cost allocation process can be broken down into four key steps:

Identify the costs to be allocated – Before costs can be allocated across the organization, management must identify which costs to allocate. A simple way to start this process is to begin with a trial balance or budget. Management can use either of these items to identify the costs that are direct, indirect, or a combination of both. Once the costs to be allocated have been identified and categorized as direct or indirect, management should then determine the most appropriate method to use to allocate those costs among the organization.

Determine the allocation methods – Once the costs have been clearly identified, management must then select an appropriate method to use to allocate the costs. Commonly used methods include allocating costs on the basis of time and effort, full-time equivalents (FTEs), square footage, and key indicators. After determining the allocation bases for the costs, the documentation to support each allocation basis should be collected. For costs allocated on the basis of time and effort this could include timesheets. Management would need to obtain data regarding the average number of hours worked per employee to allocate costs on an FTE basis. For costs allocated on the basis of square footage, management would need to calculate the square footage occupied by each department. Finally, if there are costs allocated on the basis of key indicators, the organization would need to compile program service counts, by department, or something similar. This basis can utilize organization or industry-specific methods, such as the number of clients served, the number of families placed, etc.

When possible, automate the allocation process – After the costs have been identified and appropriate allocation methods have been selected, management should consider automating the cost allocation process. In some accounting software there are allocation tools already built in to the system; however, for systems that do not have this feature, or for allocations that are more complex, spreadsheet templates can be utilized. Although preparing these tools and templates takes some time up front, once they are set up, the information they provide to both internal and external users of the organization’s financial statements is invaluable.

Document the allocation methodologies – The final, and arguably the most important, step in the process is to document the methodologies used to allocate costs in a written cost allocation policy. This written policy provides audit evidence to support the allocation methodologies used and is also a valuable resource for others in the organization to reference, especially future employees. The written policy should summarize the information discussed in the previous three steps but should also include documentation regarding how often the allocation methods should be reviewed or updated.

The Importance of Cost Allocation
Following the steps above to accurately and consistently allocate costs across an organization’s programs and supporting activities ensures the organization is in compliance with both GAAP and IRS reporting requirements. However, this process also provides management with key information for decision making. More specifically, it allows management to understand the true costs of providing services and operating programs.

With this information, management will be better informed to make crucial decisions related to identifying fundraising and cost-savings opportunities, and other management decisions necessary to remain in operations and continue to provide services to the community and beyond.

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