Understanding Functional Expenses – Part 2 of 4

In our last post, Understanding Functional Expenses – Part 1 of 4, we covered the definition of cost vs. expense. We then dove into the nitty gritty of what expenses are considered to be fundraising. The post just prior to this series, Demystifying Nonprofit Overhead, made the case for why you should care about overhead and introduced the broader topic of functional expenses.

Recall our framework: Form 990, the annual information return required of many nonprofits, as well as audited financial statements require expenses to be presented by three functional areas:

1. Program services

2.  Management and general

3. Fundraising

With fundraising expenses now covered, we can move on to management and general expenses.

But first another intermission break for vocabulary building – direct vs. indirect costs.

Direct vs. Indirect Costs

Indirect costs are not the same as overhead. Indirect costs are simply those costs that are not tied to any one purpose or functional area. Often referred to as “common costs,” they may apply to program services as well as supporting services. Examples of indirect costs include:

  • Salaries of the executive director or other staff not dedicated to specific programs or functions
  • Expenses associated with a physical building such as rent, utilities and maintenance
  • Office expenses such as copiers, phone and postage
  • Design and maintenance of a web site
  • Technology services, computer equipment and software

Indirect costs are often allocated as direct costs to the functional areas to which they relate.

As an example, say your organization operates a homeless shelter. The building that houses the shelter also contains offices for the executive director, fund development director, and program staff. All expenses associated with operating the physical building are indirect costs. These expenses can be allocated to program services, management and general, and fundraising based on square feet of usage by each function.

Say the shelter facilities and program staff offices take up 90% of the building. 10% of the building is used by the executive director’s office, development director’s office, a conference room and a small kitchen area. It’s clear that 90% of the building expenses can be allocated to program. Of the remaining 10%, we would consider how the space is used to allocate each office or room by functional area. In the end, the organization would have more than 90% of the building expenses allocated to program since common areas are used in part for programs and the executive director’s time is spent in part on program management.

In contrast, direct costs are costs that can be directly tied to a purpose or function. For example, program supplies such as baby formula purchased for a nonprofit nursery would be a direct cost. Travel to meet with a donor would be classified as fundraising; travel to a workshop on nonprofit management would be management and general; travel to visit clients receiving in-home services would be classified as program services. Other examples of direct costs are payments to contractors, advertising and direct costs of special events.

Management and General Expenses

Finally we now turn our attention to the nitty gritty of management and general expenses. This is the area most commonly thought of as “overhead.” However, as we stated last week, we don’t like to use this word with its negative connotations. It seems to imply if you could only get your act together you could reduce, if not eliminate, these pesky expenses!

Per the Financial Accounting Standards Board (FASB) glossary to the Accounting Standards Codification (ASC) which defines Generally Accepted Accounting Principles (GAAP), management and general activities are activities that are not identifiable with a single program, fundraising activity or membership development activity but that are indispensable to the conduct of those activities and to an entity’s existence. Those are strong words!

Overhead (management and general expense) is not fluff. Nor is it waste.

Overhead, referring to the expense of management and general activities, is indispensable to the conduct of an organization’s programs and, indeed, to an organization’s very existence.

You can view management and general expenses as “infrastructure costs,” because such activities and expenses create the backbone of an organization and underlie its ability to deliver programs.

Management and General Expenses per Form 990

Per the instructions to Form 990, management and general expenses include “ the salaries and expenses of the organization’s chief executive officer and his or her staff, unless a part of their time is spent directly supervising program services or fundraising activities. In that case, their salaries and expenses should be allocated among management, fundraising, and program services.” The instructions go on to list specific management and general expenses:

  • Costs of board of directors’ meetings; committee meetings, and staff meetings (unless they involve specific program services or fundraising activities);
  • General legal services
  • Accounting (including patient accounting and billing)
  • General liability insurance
  • Office management
  • Auditing
  • Human resources and other centralized services
  • Preparation, publication, and distribution of an annual report
  • Management of investments

Management and General Expenses per Generally Accepted Accounting Principles (GAAP)

Per GAAP, management and general activities include:

  • Oversight and business management
  • General recordkeeping
  • Budgeting
  • Advertising and promoting sales to customers
  • Administering government, foundation and similar contracts including billing and collecting fees
  • Informing the public of the NFP’s stewardship of contributed funds
  • Producing and disseminating the annual report
  • All other management and administration except for direct conduct of program services, fundraising activities or membership development activities

Management and General Expenses per the Feds

The Federal government’s definition of “management and general” follows the definitions used by Form 990 and GAAP closely, except they use the terminology “general administration and general” expenses.  Referring to 2 CFR Chapter II Part 200 Appendix IV, general administration and general expenses include expenses of central offices such as:

  • The director
  • Finance
  • Business services
  • Budget and planning
  • Personnel
  • Safety and risk management
  • General counsel
  • Management information systems

We’ve had the pleasure of drafting indirect cost proposals related to Federal awards. While the Feds have a variety of acceptable approaches, one method they honor follows very closely the work you are doing already to carve out management and general expenses for Form 990 and audit purposes. If you are a recipient of Federal funds, it’s nice to know you can rely on your same work for this purpose as well.

Management and General Expenses We Often See

In practice, for our nonprofit clients, we find management and general expenses often include:

  • Allocations of common costs
    • Payroll expenses for the executive director, office manager and other administrative staff based on use of time
    • Expenses associated with a physical building or office based on allocation by square feet
    • Depreciation, based on use of the related assets
    • Office expenses and information technology, based on use of staff time
    • Liability insurance based on overall allocation of program to supporting services
  • Direct expenses
    • Annual incorporation fees paid to the state
    • Accounting and auditing
    • Payroll service fees
    • Bad debt
    • Interest on a line of credit
    • Bank and merchant fees
    • Expenses of board meetings, such as printing and refreshments

You may incur other management and general expenses; this is just a list of expenses we see often. If your nonprofit incurs these types of expenses, you should report them as management and general.

Congratulations! By this point you’ve made it through management and general expenses and (if you read our last post) fundraising expenses! Everything else is program, which we’ll cover next time. Last we’ll cover approaches to tracking functional expenses in QuickBooks.

This is where we are different – we seek to provide not only the big picture, but also the detail you need to actually implement what you’ve learned in your organization. To that end, we aim to go even one step further – we’ve created a “cheat sheet” for you that will be available with the last post in this series to help you with properly coding expenses by functional area. Because we love you!


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