The allocation of expenses among program, management & general (M&G), and fundraising functions is sometimes a mysterious process, often left to chance or defaulted to SALY (same as last year), or, in certain unfortunate cases, is determined based on desired ratio outcomes. If done properly, the allocation methodologies can be as diverse as the nature of the expenses incurred.
For those wanting to “do things right,” why the confusion?
One reason is the sometimes over-generalization of the requirements, which themselves are rather sparse in the FASB Accounting Standards Codification (ASC). For example, the definition of program services found in the ASC is “The activities that result in goods and services being distributed to beneficiaries, customers, or members that fulfill the purposes or mission for which the not-for-profit entity (NFP) exists. Those services are the major purpose for and the major output of the NFP and often relate to several major programs.” Little wonder that a question often heard is, “Aren’t all of our expenses incurred in fulfilling our mission?”
A more useful reference can be found in the AICPA Audit and Accounting Guide, Not-For-Profit Entities (Guide), which provides helpful guidance in Chapter 13, Expenses, Gains and Losses.
Management and General Expense
For example, the Guide clarifies that Management and General expenses are composed of “activities that are not identifiable with a single program … but that are indispensable to the conduct of (program services) activities and to the entity’s existence.” Examples include oversight, business management, general record keeping, budgeting, financing, producing and disseminating the annual report and all management and administration except for direct conduct of program services or fundraising activities. The costs of oversight and management generally include the salaries and expenses of the CEO and the supporting staff. However, any individual who also spend a portion of their time directly providing or supervising program services should have their salaries and expenses allocated among those program service categories.
The Guide describes fundraising as “activities undertaken to induce potential donors to contribute money, securities services, materials, facilities or other assets, or time.” Examples include publicizing and conducting fundraising campaigns, maintaining donor mailing lists, preparing and distributing fundraising materials and conducting activities involved with soliciting contributions from individuals, foundations, government agencies and others.”
By giving a little thought and considering the examples of the M&G and fundraising expense categories above, the classification of program services comes into better focus.
The allocation of costs among the three categories is based on underlying relational concepts. For example, maintenance costs relating to specific classrooms in a school are direct program costs. In contrast, costs of general maintenance of the entire facility might be allocated among program, M&G, and fundraising expense categories based on the square footage of the facility utilized by classrooms, administrators and fundraising personnel. At the same time, payroll costs associated with a particular administrator might be appropriately allocated among all three categories because the individual’s time is divided among delivering educational instruction in the classroom, administering the operations of the school, and meeting with donors to solicit contributions. In this case, the payroll costs could be allocated based on the number of hours spent on each function. Overall, the two most commonly used allocation concepts we see in practice are space-related and time-related.
Potential Misuse of Allocation Methods
The Guide states, “The techniques used to allocate are common to all entities, for-profit and NFP alike. A reasonable allocation of expenses among an NFP’s functions may be made on a variety of bases. Objective methods of allocating expenses are preferable to subjective methods.” Sounds simple enough. Unfortunately, the practical application of the concepts isn’t so easy, nor is it always performed objectively. Pressures to achieve certain ratios of program, M&G, and fundraising expenses can create pressure on Boards, managers and other personnel, consciously or otherwise, causing them to allocate unreasonable amounts of M&G and/or fundraising expenses to program categories.
Where is this pressure coming from?
First and foremost, principles of good stewardship and the implicit expectation that an NFP should use its resources in the most efficient and prudent manner to ensure maximum delivery of benefits to its constituents sets the overriding tone. Then, there are several organizations that evaluate that performance, along with the financial viability of nonprofits, one of the largest being Charity Navigator. Charity Navigator’s expressed mission is “to guide intelligent giving,” and on their website they describe the various methodologies they use to evaluate the strength and viability of nonprofits. One method is the computation of “financial efficiency performance metrics,” the first of which listed is the percentage of program expenses to total expenses of the NFP. Thus, NFPs dependent upon donors for support, and/or who need positive program service metrics and evaluations to demonstrate to donors their responsible spending, may feel pressure to allocate program service expenses in a manner that shifts more costs to program services than is supported by the underlying operating realities.
What Should a Nonprofit Organization Do?
First, try to be honest and objective. Frankly, nothing short of that can ruin any organization. Next, remember that the allocation of expenses does not need to be complex—it simply needs to be defensible and properly documented. To do so, consider the following:
- Step 1 – Consider how many underlying factors for allocation exist within your operations (such as square footage and occupancy of the facility; percent of hours for allocated personnel).
- Step 2 – Take the list of general ledger expense accounts and determine which accounts contain direct costs for program, administrative and fundraising categories and which contain costs to be allocated. The direct costs already recorded stay where they are; the allocable costs are the ones to spread across categories, which often is done using a matrix.
- Step 3 – Consider which allocation factor is most appropriate for each specific expense requiring allocation. Using the appropriate factor, calculate the portion of expenses for each category across the categories in the matrix. Note that not all expense accounts include portions of the three categories—some may be allocated only between program and administrative categories, others between administrative and fundraising categories. Document the allocation methodologies and resulting formulas on the matrix for later reference.
- Step 4 – Review the matrix and consider whether the total program, administrative and fundraising costs make rational, economic sense given the specific characteristics of the nature of the expense and the nature of your operations. Do the same on an overall basis for all categories of functional expenses. For example, the amount of fundraising costs should be higher if the organization is actively conducting a building or endowment fundraising campaign.
An often overlooked but very important step is to fully communicate with donors and customers the core factors of your operations and how those affect your reported financial metrics. Almost without exception, more information is better when it comes to presenting the financial results of your operations and how they might differ from other organizations to which you might be compared.