How to Allocate Functional Expenses in Nonprofit Organizations

How to Allocate Functional Expenses in Nonprofit Organizations

February 14, 2024

Considering most nonprofit organizations have limited funding, how they allocate their resources is critical to fulfilling their mission. Individuals, corporations, or other potential donors can easily see this allocation by reviewing a statement of functional expenses. Generally, resources are allocated into three natural categories: program, administrative, and fundraising costs. Below are a few best practices and considerations for allocating functional expenses in a nonprofit organization.

The first step in allocating resources is to determine which natural category the expense relates to.

Program expenses are costs related to fulfilling the organization’s mission and programs. These are typically payroll expenses for employees who run the program(s), supplies for the program, and other direct program related activities. An organization can have multiple program categories on the statement of functional expenses. Ideally, most nonprofit organizations should have 70% or more of total expenses allocated to this category.

Administrative expenses are costs related to the overall support and function of the organization. These costs are not directly identifiable with any other specific function.

Fundraising expenses are costs incurred to raise funds. These include costs for special events, marketing, and salaries for fundraising employees.

After determining which natural category an expense relates to, the next step is to determine how much of each natural classification or expense is attributable to each category. For example, salary and wage expenses (a natural classification) are usually related to all categories. Depending on the natural classification of the expense, different allocation methods may be appropriate.

Direct allocation is used when expenses are attributable to a specific category. For example, salaries of a fundraising employee directly pertain to fundraising and should be wholly allocated to the fundraising category.

Indirect allocation is used when expenses are attributable to multiple categories. These costs must then be allocated into their respective categories. Management will allocate these items based on estimates, considering the nature of the expense and how it relates to the functional category. See the most common types of indirect allocation and allocation methods below.

          Rent: allocated based on square footage.

Salaries and wages (employees working in multiple categories): allocated based on time and effort spent by employee.

Once the organization has developed a methodology for allocating its resources, a statement of functional expenses can then be prepared (see example below). It is also important to note that organizations should monitor and evaluate the methodology annually to ensure that costs are properly allocated and presented.

Click here for a printable pdf version of this example.

Please contact Larson & Company with any questions you may have regarding allocating functional expenses in nonprofit organizations.