Understanding Functional Expenses – Part 3 of 4

This post is the third in a series of four posts on functional expenses. An introductory post, Demystifying Nonprofit Overhead, clarified the term “overhead” and made the case for why you should care about it. In Understanding Functional Expenses – Part 1 of 4, we covered the definition of cost vs. expense and went into the detail of fundraising expenses. In last week’s post, Understanding Functional Expenses – Part 2 of 4, we covered direct vs. indirect costs and explored definitions of management and general expenses.

Today we are ready to tackle program service expenses.

Focus on Program Service Expenses

As we’ve observed, donors are interested in what you spend on programs vs. what you spend on things that are NOT programs (support services). While we may argue that the impact of program services on beneficiaries is more important, such impacts can be hard to measure and even harder to compare from one nonprofit to the next. Hence the focus on functional expenses which are easily obtained from Form 990.

Program Expenses per Form 990 and Generally Accepted Accounting Principles (GAAP)

Form 990 instructions define program services as “mainly those activities that further the organization’s exempt purposes.”

According to Generally Accepted Accounting Principles (GAAP), program services are “The activities that result in goods and services being distributed to beneficiaries, customers, or members that fulfill the purposes or mission for which the not-for-profit (NFP) entity exists. Those services are the major purpose for and the major output of the NFP and often relate to several major programs.”

To summarize, program services are those activities that fulfill the organization’s mission. But how do you assign expenses to programs?

Assigning Expenses to Programs

As explained in our last post, direct expenses can be directly tied to a purpose or function. Direct program expenses could be cribs, toys and snacks for a nursery. A job placement service may incur expenses for aptitude tests. A staff person may manage shelter services so that person’s wages would be coded directly to that program.

Indirect costs, also called common costs, pertain to more than one functional area. You need to identify common costs in your organization and use a logical way to allocate them to the three functional areas (program services, management & general and fundraising), in essence treating the allocated portions like direct costs.

Payroll is usually treated as a common cost since employees are often responsible for duties across more than one functional area. The new Accounting Standards Update, ASU 2016-14, directs us to allocate staff to programs and fundraising based on their time spent on the “direct conduct or direct supervision” of these activities. Any remaining time is considered to be management and general. ASC 958-720-55-172 provides an example of how to allocate the compensation of a chief executive officer. (You can access the Accounting Standards Codification for free at FASB.org.  ASU 2016-14 is effective for fiscal years beginning after December 15, 2017.)

Program Expenses We Often See

In practice, for our nonprofit clients, we find program expenses often include:

  • Allocations of common costs
    • Payroll expenses for the executive director and other staff based on use of time
    • Expenses associated with a physical building or office based on allocation by square feet with common areas further allocated based on use of staff time
    • Depreciation, based on use of the related assets
    • Office expenses and information technology, based on use of staff time
    • Liability insurance related to providing program services
  • Direct expenses
    • Program supplies
    • Expenses of program volunteers
    • Professional education related to programs
    • Travel to clients or for other program purposes
    • Payments to outside contractors who provide program services

You may incur other program expenses; these are just examples of program expenses we see often. Also, the methodology you use to allocate common costs may be different from the approaches listed above.

ASU 2016-14 requires audited financial statements to disclose the “methods used to allocate costs among program and support functions.” If you have been through an audit, you likely have had to support allocations of common costs for your auditors. The new standards add the requirement to disclose your methodology in the notes to the financial statements.

As you can see, the process of assigning and allocating expenses to functional areas is subject to estimation and judgment. It is far from an exact science!

In our next post, Understanding Functional Expenses – Part 4 of 4, we go over options for tracking and reporting functional expenses in QuickBooks (or other bookkeeping software). We’ll also share a guide and “cheat sheet” to help you with developing functional allocations of common costs and reporting functional expenses on Form 990. We know this is a challenging area for small nonprofits and that you’d rather be working on making the world a better place. We appreciate all that you do and hope we can make your world a better place.


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