Elegant Allocations in Nonprofit Accounting

• September 27, 2019
• Curtis Klotz

In our previous blogs in this series, we have outlined the building blocks of an elegant financial system: elegant cost centers and elegant charts of accounts. Now it is time to use those blocks to build better financial reports. The point of taking the time to design an elegant accounting system is not only simplicity, it is power – decision-making power. For nonprofits, we strengthen our decision making when we can see the whole truth about our programs and their finances. For a complete view of the financial state of any one program, we need to see the full range of resources required to support it. We do that by allocating costs.

The difference between shared direct costs and administrative costs

Nonprofits sometimes misunderstand the difference between shared direct costs and administrative costs. Just because a resource is used by more than one program or functional area (administration or fundraising) does not define it as an administrative cost.

A high-level definition of administrative costs (aka, management and general; aka, indirect) is that they are resources used for the overall management of the entire organization. These are often expenses related to board governance, financial accounting, human resources, and organization-wide staff meetings. The resources deployed to these purposes are benefitting the organization as a whole.

Shared direct costs (aka, shared program costs; aka, allocable direct costs) are resources that each program uses to accomplish its mission work. Nonprofits most often acquire these resources centrally and make them available to each program as well as the administrative and fundraising functions. It is generally not possible (or would be prohibitively expensive and time-consuming) to track the exact amount used by each program or function. These are often expenses like office supplies, occupancy, technology, and equipment. The resources deployed to these purposes are benefitting each program and each functional area.

A two-step approach to allocating nonprofit expenses

To allocate costs properly, we take a two-step approach. The first step is to allocate shared direct costs. The second step is to allocate the expenses aggregated in the administrative and fundraising categories. Prior to taking either step, we use our elegant cost centers and elegant chart of accounts structure to capture these expenses accurately.

To organize shared direct expenses best, we create a “To be allocated” or “Allocable expenses” cost center. This allocation cost center sits parallel to the other functional cost centers (programs, administration, and fundraising) in our structure. When incurring expenses and coding them into our accounting system, we choose this cost code. This step organizes all of our shared direct costs into one easily identifiable category.

Having a “To be allocated” coding option makes entering accounts payable invoices into the accounting system simpler. We avoid having to apply allocation percentages to every transaction. Instead, we apply the allocations to the total amount captured in the “To be allocated” cost center.

 

Choosing an allocation method for nonprofit expenses

Any allocation method we choose for our shared direct costs must be reasonable, justifiable, and consistently applied. The method we choose may need to be different from line item to line item. To be most useful to us in our decision-making, we tie our allocation methods to drivers that influence how much a particular program or cost center uses a particular resource.

For example, many nonprofits have office equipment costs for computers, monitors, and network servers. Each program of the organization uses this technology in support of mission-based programmatic work, as well as to support fundraising and administrative activity. The nature of the equipment makes it difficult to measure specifically what pieces of equipment are being used by which program when. The burden of tracking usage to that level of detail is prohibitive. Instead, one reasonable way to allocate the total cost of the equipment would be to use the percentage of staff hours worked in each program area or cost center. Staff hours drive equipment usage. The more time staff spend working on a particular program or functional area, the more they are using the equipment for that purpose.

Fundraising and administration get their fair share of allocated costs

Because the functional areas of fundraising and management and general also benefit from shared direct costs, our allocation method must apportion a fair share of these expenses to these functional categories, too. In the example above, we allocated equipment costs to management and general, to fundraising, and to each program according to the number of staff hours tracked in each area. While the allocation method might differ between line items, we must allocate each shared costs to all of our cost centers including management and general, fundraising, and each program.

Getting to true program costs

Once we have allocated all of the shared direct costs, we move to the next step – allocating management and general costs and fundraising costs to programs. This step is crucial in giving us the full picture of what resources we need to fulfill our mission goals successfully in each program area. 

Unlike shared direct costs, we do not need to allocate management and general costs or fundraising costs by line item. We can allocate these costs in aggregate, by using elegant chart of accounts line items created especially for this task. We often call these line items “Administrative Allocation” or “Fundraising Allocation.” The name is optional, though it should communicate how the line items are used.

The allocation method we choose for management and general is likely to be different from the one we choose for fundraising. Again, we try to match the allocation method to what drives the expense. For management and general expenses, two common methods used are the percentage of direct expenses and the percentage of FTEs (full-time equivalents). For the percentage of direct expenses, we would take the total expenses of each program area and fundraising prior to allocating the management and general costs. To arrive at our percentages, we divide the total direct expenses of each cost center into the total amount of direct expenses minus the administrative cost center. We leave out the administrative cost center because we will be allocating this amount.

Using the FTE method, we would rely on our timekeeping system to provide us with the total FTEs tracked to each cost center. We would divide the FTEs for each cost center by the total FTEs (again, minus the administrative cost center). This provides us with the percentage we would use to allocate management and general costs across each of the programs and fundraising.

Allocating fundraising costs is a radical step towards true programs costs

Allocating fundraising costs is a step many nonprofits have never taken. We are aware that some of our larger donors do not allow us to include fundraising costs in our proposal budgets. Not allowing a cost does not mean the cost disappears or is not part of the true cost of running each of our programs.

We save the fundraising allocation for last because we must assign fundraising, like each of our program areas, its fair share of management and general costs. Our aggregate total expenses for fundraising includes all the direct fundraising expenses, its proportion of shared direct costs, and its share of allocated management and general costs.

The allocation method for fundraising should tie to what drives expenses to each program area. One common method of allocating fundraising costs is to calculate the percentage of contributed income received by each program area. This could include just donor-restricted contributions or it could be both donor-restricted and general support contributions. Once the percentage is calculated, we use it to allocate the aggregate fundraising expenses across each program area using the “Fundraising Allocation” line item.

Using true program costs to elevate financial decisions

Setting up an elegant chart of accounts and doing the extra work of allocating expenses across programs is all in service of heightened decision-making processes. Knowing what each of our programs really costs to operate gives us a better chance of raising money to cover the full costs. Knowing true program costs allows us to compare more accurately the mission impact of each of our program areas. When choosing where to invest our resources, using elegant allocations gives us a more sophisticated understanding of what outcomes we are achieving and at what cost.

Taking the time, effort, and expense of developing an elegant financial system has benefits beyond just the simplicity it offers. Raising up the quality of our accounting and financial reporting gives us the ability to think more strategically. Investing in the core infrastructure of our nonprofit is wise use of our resources to ensure a more effective and efficient organization over the long run.

Practical application coming next

Our next blog will provide practical examples of how to apply the principles above to building elegant allocations in Sage Intacct accounting software. Please subscribe to the blog to receive notice of our next posting. We regularly share on Elegant Financial Systems and other topics related to innovation in nonprofit finance.

 

Tags: allocation methods, cost allocations, full-cost accounting, nonprofit accounting, nonprofit accounting systems, nonprofit cost centers, nonprofit finance, true program costs, Accounting, Building sustainable nonprofits, Finance departments, Nonprofit general | Comments Off on Elegant Allocations in Nonprofit Accounting