All organizations typically have direct costs (items that relate directly to a program or a function of the organization) and shared costs (costs that benefit more than one functional area). Assigning direct costs is relatively easy, particularly with program costs. It is more difficult to develop a good method for allocating shared (or indirect) costs. Good cost allocation plans are essential for proper reporting of costs and are useful in making management decisions. Conversely, having a poor allocation plan may give a false impression of how well a nonprofit uses the resources provided to run the organization. When donors believe an organization is a good steward of donated funds, they give more readily. So, it is important to properly allocate expenses between program costs, fundraising, and management and general.
Spend some time in determining a logical plan that reflects the reality of what actually happens in your organization from day to day. In addition to providing a realistic picture of the costs of various programs and activities for internal use, the allocation of costs will appear on your Form 990 and perhaps reports to outside agencies. Cost allocations are also used in recovering costs for reimbursable expenses, which is how many grants are paid, and they directly impact your bottom line and related fundraising decisions.
There are a number of ways to allocate expenses, and some of the most common are:
- Payroll: allocations based on the percentage of total actual time worked or payroll dollars charged to various programs, fundraising or management. This method requires employees to track time for various duties.
- Square footage: allocations are based on the proportionate space occupied by each functional area of your building.
- Units of service: allocations are based on the service provided.
An organization might require a method not mentioned above or may require more than one method for allocating costs. Multiple methods might include using payroll for personnel related expenses and square footage for office related costs (utilities or rent). You will have to pick and choose which method (or methods) works best for your organization both in terms of accuracy of available data and available time to implement. Whatever method(s) you decide to use, it should be used consistently, it should be in writing and it should be approved by the executive director or chief financial officer. You should be able to explain the allocation process if questioned about the validity of the method(s) employed. Above all, it should be reasonable and consistent, not a method you would regret using if it was described to outside parties.
If you need guidance on cost allocations, please contact your local Hawkins Ash nonprofit representative.