Tag Archives: Overhead

Cost Allocation

The Secrets of Cost AllocationA few years back I co-wrote an article about getting accurate numbers from your financial system for the California Association of Nonprofits that was based on a workshop I developed. These next two blog posts will excerpt some of the material from that piece. For folks who would like the whole article you can click the above link. This first post will be on cost allocation, the second post will be on setting up a functional accounting system.

Cost allocation should not be ignored as a cornerstone of your financial management and reporting. It is critically important to all aspects of your organization: How you budget from year to year, how you make management decisions, how you appear to potential supporters and the amount you are reimbursed for services all depend on proper and consistent cost allocation.

Allocation can look tricky at first glance, and initially it can be difficult to set up a reliable, consistent and simple system. But once your system is in place, it should go rather smoothly and become a routine part of your accounting and financial reporting process. Put some thought and planning into developing a method that works for you and that best reflects the reality of what happens in your organization from day to day.

Cost allocation is a method for apportioning shared expenses or shared costs (also called common costs, or directly allocable costs) across functional areas. It generally works well to “dump” all shared costs into cost centers – temporary holding tanks for functional areas – and then allocate them out across those functional areas on a periodic basis, usually monthly or yearly.

As an example say you get a bill from your office supply store for $500, you would initially expense it to “Supplies” and code it to a cost center. But at month-end, year-end or whenever you allocate costs, you will want to divide out that $500 between the specific functional areas that actually used the office supplies. So you might end up with $50 of that bill being allocated to management, $75 to fundraising and $375 proportionately across various programs. Your allocation method is your way of deciding what percentage of that bill to apportion to each functional area.

Cost allocation is important because, done accurately and consistently, it can provide a realistic picture of what different programs and other activities cost. Your allocation method also determines the percentages of program, management and fundraising that will appear on your Form 990 and other reports – numbers that potential donors use to judge your organization’s worthiness for their contributions. It is also used in cost recovery for reimbursable expenses, directly impacting your bottom line and related fundraising decisions.

There are a number of cost allocation methods out there, and several of the most common are:

  • Payroll. Allocations are based on a percentage of the total actual time worked or the total payroll dollars charged by all employees in each functional area. For example, four employees’ time sheet data shows that they spent 15 percent of their aggregated time during the last payroll period on Program A, 35 percent of their aggregated time on Program B, 25 percent on program C, 15 percent on Administration and 10 percent on Fundraising.
  • Cost-to-cost or direct cost. Allocations are based on the previous year’s percentage breakdowns for each functional area.
  • Square footage. Allocations are based on the proportionate space occupied by each functional area in your office or worksite. For example, Program A occupies 10 percent of your office space, Program B occupies 20 percent, Program C 50 percent, Administration 5 percent and Fundraising 15 percent. This method is useful for allocating rent, utilities and other occupancy-related costs.

Your organization might require a method not included above, or more than one method of cost allocation, for example using payroll for personnel-related expenses and square footage for office-related expenses. You might have to pick and choose which method or methods work best for your organization in terms of both your available time and the accuracy of the data produced. That said, if you have many different allocation methods, some consolidation might be in order. Whatever method(s) you decide to use, you should use it consistently, put it in writing, have it approved by the executive director and be able to back it up if questioned about it. It should also be honest and ethical – not a method you would regret being described in a front-page story in your local newspaper.

If you would like to learn about creating a cost allocation policy for your nonprofit please click on the image below.

My Financial Management Plan

Nonprofit Administrative Costs

Two questions recently got me thinking about administrative and overhead expenses.  Below are the questions and the answers I sent:

Question #1: Should a depreciation expense be included in the calculation when looking at the percentage of administration expenses to total operating expenses with a nonprofit?

Answer: It is a good idea to allocate and include depreciation expense in program(s), admin and fundraising. This helps show the cost of doing the work, as at some point equipment will have to be replaced and it is good to know which program is “using” it the most. If your organization does an audit it will show depreciation as a part of your total expenses and allocate it across all your functional areas.

Question #2: We have two independent contractors doing work for our nonprofit. Is the money paid to these people “administrative costs” straight across, or can we separate it out by program? Doesn’t this all come under administrative costs?

Answer: How you code the transactions will depend on the type of work you paid for. If the consultants worked on administrative tasks, their fees would be an administrative cost, if they worked in program areas it would be program costs. Just because the expense is for an independent contractor does not mean it is automatically an administrative cost.

I’ve linked to this topic in my Q&A section and below is what the IRS says about administrative costs in the updated Form 990 instructions on page 33:


Click on the image for a larger / clearer view

A nonprofit’s expenses are classified by what they were used for within the three broad categories / functional areas of administration, program and fundraising.  Program costs are considered direct expenses, expenses that have a direct effect on fulfilling the mission of the nonprofit organization.  Administrative costs are indirect expenses, they affect the mission of the organization indirectly.  The organization can’t get by without those expenses but, according to the IRS and others, they have no direct effect on the mission.

This point, of course, can be argued and I think it is where much of the confusion resides when talking about classifying nonprofit expenses.  But this is the world we operate in and those are the rules, so it is best to make sure we understand the rules so we can present our numbers in the most honest fashion to show what it costs to do the work we do.

Another nice breakdown of what administrative / overhead costs are comes from this post from the Nonprofits Assistance Fund.  It links to this pdf of overhead cost definitions which is very handy.  That post also brings up the specter nonprofits face of spending too much on overhead expenses and the focus on the financial ratio of administrative expenses to program expenses.  While that may be a useful figure, I think we need to always keep in mind just what expenses are admin and what are program so we know just what is being measured.  Then we need to make sure that as a sector we are all labeling our expenses the same way.

And while we are looking at those ratios we need to look at the nonprofit’s ability to deliver its mission.  One financial ratio used in isolation is no true measure of any organization.  Only by looking at both the numbers and the program outcomes can we judge whether an organization is effective or not.

FASB 116 and 117

Since we talk about them so much and they govern so much of what we do in keeping our nonprofit’s books, I thought I would link to the sources and list a quick summary of them.

Statement No. 116 Accounting for Contributions Received and Contributions Made

This Statement establishes accounting standards for contributions and applies to all entities that receive or make contributions. Generally, contributions received, including unconditional promises to give, are recognized as revenues in the period received at their fair values. Contributions made, including unconditional promises to give, are recognized as expenses in the period made at their fair values. Conditional promises to give, whether received or made, are recognized when they become unconditional, that is, when the conditions are substantially met.

This Statement requires not-for-profit organizations to distinguish between contributions received that increase permanently restricted net assets, temporarily restricted net assets, and unrestricted net assets. It also requires recognition of the expiration of donor-imposed restrictions in the period in which the restrictions expire.

Statement No. 117 Financial Statements of Not-for-Profit Organizations

This Statement requires that all not-for-profit organizations provide a statement of financial position, a statement of activities, and a statement of cash flows. It requires reporting amounts for the organization’s total assets, liabilities, and net assets in a statement of financial position; reporting the change in an organization’s net assets in a statement of activities; and reporting the change in its cash and cash equivalents in a statement of cash flows.

This Statement also requires classification of an organization’s net assets and its revenues, expenses, gains, and losses based on the existence or absence of donor-imposed restrictions. It requires that the amounts for each of three classes of net assets-permanently restricted, temporarily restricted, and unrestricted-be displayed in a statement of financial position and that the amounts of change in each of those classes of net assets be displayed in a statement of activities.

This Statement amends FASB Statement No. 95, Statement of Cash Flows, to extend its provisions to not-for-profit organizations and to expand its description of cash flows from financing activities to include certain donor-restricted cash that must be used for long-term purposes. It also requires that voluntary health and welfare organizations provide a statement of functional expenses that reports expenses by both functional and natural classifications.