Cost Allocations for Nonprofits: What’s the Fuss all About?

Nonprofits are facing increased scrutiny from state and local agencies when it comes to the functional allocation of expenses reported on financial statements, tax returns and cost reports. Why all the fuss? Governments are looking for justification for budget cuts, led mainly by the rationalization that nonprofit organizations are not running as lean as they should. Unlike public companies, nonprofit expenses are reported by their functional classification on the statement of activities, as required by generally accepted accounting principles (GAAP). This system involves allocating and reporting expenses by major classes of programs and supporting services.

While functional reporting may bring increased scrutiny, it does have significant benefits for nonprofits. The method allows donors to have more meaningful information about an organization’s programs and activities, and the costs involved in fulfilling that organization’s mission. Cost allocations are also important because they can (when done accurately and consistently) provide a realistic picture of the total cost of different programs—information that is critical in today’s economic environment as nonprofits stretch reduced resources over multiple programs and determine which programs to discontinue. Finally, allocation methods impact the percentages of program, management and fundraising that will appear on the Form 990 and other reports—numbers that potential donors use to judge an organization’s worthiness for their contributions.

I am frequently asked how much an organization should spend on program expenses versus supporting services. My response is to consider several factors, including:

1. Size of the Organization: There is a minimum infrastructure that is required for any organization. Smaller nonprofits (operating budgets under $5 million) will generally have a higher percentage of supporting services to maintain proper internal controls, technology, and staffing balance. Conversely, larger organizations (operating budgets in excess of $100 million), generally achieve smaller percentages of supporting services due to the achievements of economies of scale in their cost structures.

2. Funding Mix: Public versus private funding will also dictate the percentage of the supporting services that an organization will have. Some federal contracts put caps on supporting services at lower percentages—around 6% to 8%. For nonprofits with operating budgets that are small to midsized, this could require private donor dollars to support a larger infrastructure.

3. Complexity: High program expense could mean an organization is under-investing in technology, personnel support and development, or financial planning and audit services. Low program expense may indicate that an organization is not being as efficient as it could be with donor contributions. When comparing program expenses to supporting service expenses, there is no “right” percentage ratio for all nonprofit organizations. Instead, I recommend using the rations of similar organizations as a starting point for comparison.

What challenges have you faced in understanding and planning for cost allocations?