One of the major differences between for profit and nonprofit accounting is the method used to categorize expenses known as direct cost allocations.
Beginning with this post, Araize is launching a series of educational vlogcasts, combining a video lesson with a blog post. Episode 1 focuses on direct cost allocations and why your nonprofit needs to understand how it works.
How nonprofit accounting differs from for-profit accounting
Nonprofits are subject to a unique accounting requirement that requires the reporting of expenses according to the purpose for which they are incurred. Allocating costs to functional areas is the cornerstone of a nonprofit’s financial management and reporting. This process is one of the more challenging and misunderstood areas of preparing a nonprofit’s financial statements.
Financial statements prepared under FASB 116/117 break down expenses into the following functional categories: program and support services. Understanding the different functional categories is crucial to accurate functional allocations. We reviewed the importance and definition of functional expenses in a previous blog post.
Planning for your direct cost allocations
Now that you have an understanding of functional expenses, when it comes time to record the expenses incurred by your organization, you may need to develop a direct cost allocation plan to properly distribute expenses to the correct functional area. It is critically important to all aspects of your organization to have a defined allocation plan. The allocation of expenses will have a direct effect on your budgets, how you appear to donors, how you are reimbursed for expenses by funding sources, and provide critical data on the viability of your programs.
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How direct cost allocations work for your nonprofit
A nonprofit organization pays their cell phone bill for $1,000. A for profit would simply categorize it as telephone expense as simply a cost of doing business. But, for a nonprofit, the bill needs to be analyzed to determine who has a cell phone and which department they work in. Upon inspection we determine that the Executive Director and Fiscal Director both have cell phones. The Development Director and his associate each have a cell phone. And finally, there are six phones used by employees in the After School and Day Care Programs. So the $1,000 cell phone bill is allocated to the following functional areas:
Management and General – $200
Fundraising – $200
Program Service Expense – $600
Now when reading the financial statements, we can easily see that the $1,000 cell phone expense was mainly incurred to support its mission, with a portion allocated to management and general and fundraising.
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Tips for implementing your direct cost allocations
- Adopt and document an accepted allocation methodology, such as square footage for office space, children in care, and like the cell phone example, number of units to be allocated.
- It is important that the methodology used is documented so it can provide justification to auditors and the readers of the financial statements.
- Identify the expenses that are directly allocated to one of the functional categories, or that need to be allocated amongst several categories using an indirect cost allocation, which will be covered in a future blog.
- Keep timesheets for all employees, if their responsibilities overlap different departments and programs.
- Remain consistent with the functional and cost allocation plan. Review the allocation methodology on a periodic basis, and if necessary, make and document any necessary changes.
- Use an accounting system that allows for the segregation of accounts by multiple segments to allow for proper allocation and generation of financial statements.
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Direct cost allocations are important because it can provide a true determination of your organization’s financial picture and how much each of your programs costs in relation to your support services. Your allocation method also determines the amount of program, management and fundraising that will appear on your Form 990 and other reports. This can influence potential donors on their decision to donate to your organization.
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Did you find this article useful? We welcome your thoughts and comments.
I am currently volunteering for a Community Arts Performing Center (not-for-profit) project whereby we are trying to figure out the cost per square foot of “rentable space.” The Center does not pay rent. Though the center does have various programs throughout the year that utilize the various spaces (e.g., computer lab, dark room, after school programs, auditorium, etc.). The auditorium is unique in that if there are staged productions, it requires audio, visual and lighting staff. We are trying to figure out what is the cost to operate each of the spaces. We do have the total square foot of the entire center broken down by each room as well as the total number of hours it is utilized plus general administrative costs and facilities management costs. Is there a standard formula that we can use to figure out how much it cost to operate each room. Any suggestions are greatly appreciated!
Joseph Scarano says
To calculate the cost per square foot, add all expenses and divide by the total number of square feet in each space. You can also add a percentage of your administrative costs to the total costs to operate each space as part of your total costs.
Hope this helps,
Julie Cunningham says
I’m in a 501(c)(3), small non-profit (a woman’s club with a mission of supporting art, education and community service). 75 members. Annual budget of about 200K. I was intrigued by your article because I am concerned that our club is becoming “siloed.” e.g. those who work on the fundraiser see that as “their” event and proceeds, and likewise (but to a lesser degree) for our large arts event, and for building rentals. I would like to see every event/activity that generates revenue contribute to operations, facilities, and charity so that all members feel responsible for every facet of the club, not just their area. I was thinking of proposing a model like you’ve described. Any advice on how to convince members that this is best for the club? I need buy-in philosophically, and also from those who will want to see the practical advantages. We have a part-time, paid accountant. Everyone else is volunteer, including treasurer. Thanks.
Joseph Scarano says
It seems obvious, but you need to develop a culture around your club of “All for one, and one for all.” It all starts with communicating to your entire staff the vision and purpose of your club and what resources are needed to execute the vision. It starts with developing a budget for your operations, broken down by functional area – Management and General, Program (Mission) and Fund Raising. As part of the budget, you will need to identify the source of the revenue needed to fund each of these areas. The development team has to understand that their efforts are necessary for funding your operations and without their events, you could not fulfill your mission. Hope this helps.