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Functional Expense Classifications
Nonprofit organizations are constantly under scrutiny as to how they allocate their functional expenses in their statement of activities. Unlike for-profit entities, NPOs must provide a statement of activities in the financial statements about expenses reported by their functional classification in order to assist outside individuals (like donors and grantors) in evaluating the organization, its use of resources and cost of services.
Functional classification can be reported into two areas:
Program services: activities that result in goods and services provided to beneficiaries, customers and members, which fulfill the mission of the organization
Supporting activities: all activities other than program services, which include management and general, membership development and fundraising activities
NPOs report these activities in a separate statement known as the "statement of functional expenses." While only some NPOs are required to provide a statement of functional expenses, like voluntary health and welfare organizations, all NPOs are strongly encouraged to do so.
What is a Statement of Functional Expenses?
The statement of functional expenses details expenses by their natural classification, such as:
Salaries
Benefits
Rent
Depreciation
These expenses are listed in a matrix format and are meant to support the effectiveness of your organization?s spending and activities.
Potential donors, funding sources and regulators will use this information to evaluate the relationship between your organization?s program and supporting expenses, by examining key ratios like:
Program expenses to total functional expenses
Administrative expenses to total functional expenses
Fundraising to total functional expenses
Fundraising expense to total contributions
Have a Written Plan
One of the best practices and critical elements of a functional allocation methodology is documenting your allocation plan in writing. This written plan helps your governance board, auditors and any other users of the financial statements understand your allocations. It is important that you know the type of expenses that are directly (or indirectly) allocated, as cost allocation can be important in terms of grant reporting and determining the success of a program.
How Indirect Expenses Can Be Allocated
Time expenses
One of the most popular methods of functional expense allocation uses timesheets to allocate expenses based on an employee?s use of time within the organization. In instances where allocation of time is not available or practical, you can allocate square footage, actual usage or percentage of direct costs.
Management and general expenses
Management and general expenses can include:
Oversight
Business management
General record keeping
Budgeting
Financing
Soliciting funds (other than contributions and donations)
Disseminating information to inform the public regarding your NPO?s stewardship of contributed funds
Producing and disseminating the annual report
All other management functions not related to program or fundraising purposes
Fundraising expenses
The majority of nonprofits have some type of fundraising expenses. These expenses may include:
Publicizing and conducting fundraising campaigns
Maintaining donor lists
Conducting special events
Preparing and distributing fundraising materials
In the End
The best ways to optimize the functional allocation is to be consistent with the allocation methodology, and be timely when updating your methodology with any changes in your cost structure, including:
Adding or deleting office space
Adding or discontinuing programs
Entering into new debt
Adding or deleting staff positions
Your organization should periodically evaluate your method of classification and contact a nonprofit accounting specialist if you determine overhaul is needed.
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