It is not incumbent upon a nonprofit organization to show a profit, but like any other business entity, it needs to maintain financial health and stability to achieve its mission. To make sure this happens, contributors, grantors, board members, administrators, the public and the IRS all demand a high level of resource management and compliance.
Cost allocation—an accounting process that assigns and divides expenses among categories, classes and items—is one way nonprofits can practice good financial management, make better decisions and communicate more effectively. It allows you to adapt to changes, identify trends and make informed decisions on issues such as:
- Which program and service areas require additional funding, and which do not;
- Whether additional real estate occupancy would create further opportunities or issues; and
- The effectiveness of program services based on existing personnel.
The true costs of programs and services are elusive. They tend to dissolve into the overall financial picture typically discussed at management and governance meetings. While discussion around cash flow and budgeting are essential to sustaining operations, cost allocations are also important—they allow you to understand the total cost per unit of service for each program service you offer. The fundamental question to be answered is whether an expense should be charged to just one activity or program, or if it should be allocated among multiple functional areas.
Categories and Methods of Allocation
Establishing the appropriate expenses to allocate based on shared program and administrative costs provides accurate cost reporting. Some examples of allocation categories might include:
- Costs related to vehicles (shared fuel, maintenance, insurance, licensing, fees);
- Costs related to occupancy (shared rent, utilities, telecommunication, insurance, contracted services, repairs);
- Fringe benefits for employees (shared agency costs, funding arrangements, insurance);
- Shared program costs (shared supplies, recruiting, contracted services); and
- Administrative costs (shared compliance, personnel management, information technology).
These categories will not be the same for any two organizations. Once they are identified, you can develop the methods of allocation that will be applied consistently to these groupings of expenses. Thoughtful consideration should be given to the method to produce the most accurate, complete picture of an organization’s financial health. Methods may include:
- Program hours (applied to shared staff costs, program costs, occupancy and administrative expenses);
- Percent of wages (applied to fringe benefits, occupancy and shared administrative expenses);
- Percent of revenue (applied to fringe benefits, occupancy and shared administrative expenses); and
- Square feet (applied to shared occupancy costs for facility).
The rewards of integrating cost allocation into your accounting system include more accurate and relevant financial statements for
internal and external review. Combined with program utilization data, you can make more informed decisions about the financial impact your services have on achieving your mission.
Cost allocation can produce fundraising metrics that show you are using donations and grant support responsibly, maximizing each dollar and creating the greatest impact. Consistent allocation policies can also be calculated on interim financials, increasing the transparency and accuracy of interim reports for staff, boards, committees and stakeholders.
And let’s not forget your governing board. Using cost allocation, you can break down profits and losses into individual programs, making it possible to build realistic budgets, improve operations and think strategically about mission-focused growth.
An Example: Your Utility Bill
Say that your organization receives a $1,000 utility bill for a multi-use facility that houses both administrative offices and program service areas. If the full amount is entered as a general expense, it doesn’t truly reflect how the funds are being used or what segments of the organization are benefiting from the expenditure. The $1,000 would appear on financial statements as an expense to allocate using a predetermined allocation method.
It could, for example, be allocated to administration and the six program areas that utilize the facility. Percentages may be 10 percent ($100) for administration and 90 percent ($900, or $150 for each of the six areas) for program services. When preparing your financial statements, these costs will be divided among the programs to reflect their true costs of operation.
Best Practice: A Well-Documented Plan
Since allocation methods and categories can change from one organization to the next, auditors, financial statement users and many grantors—including state and federal government agencies—typically require grantees to provide complete documentation of their cost allocation methods. Documenting the calculations and assumptions for categories also allows for clarity in implementation and consistency in the application of the methodology. PM
Dan Bender is a principal in the CLA (CliftonLarsonAllen) nonprofit practice. He can be reached at dan.bender@CLAconnect.com or (309) 671-4500.
The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment, or tax advice or opinion provided by CliftonLarsonAllen LLP to the reader. For more information, visit CLAconnect.com.