If you’re a nonprofit or federally funded organization, allocating expenses by function isn’t optional, it’s necessary. Functional expense allocation helps you meet IRS, GAAP, and federal reporting requirements, while also showing donors and governance how your organization uses its resources to advance its mission.
Binding Requirements
Nonprofit organizations are required to allocate expenses by functional categories (program, management and general, fundraising) in addition to natural categories (personnel, professional fees, office expenses, supplies, etc.). This requirement comes from the following:
- IRS Form 990, Part IX, Statement of Functional Expenses
- Audited financial statements, under Generally Accepted Accounting Principles (GAAP)
- Federal reports, when receiving government or grant funding
Desired Transparency
Donors and funders want to see that the majority of your resources are supporting your mission (i.e. program expenses function). Clear functional allocation demonstrates that your organization manages funds responsibly.
It also helps tell your nonprofit’s story, showing the real investment it takes to deliver programs effectively and keep your organization running sustainably.
The Four Primary Steps for Proper Expense Allocation
There are different processes, but here is the high level steps your nonprofit can take to allocate effectively:
Step 1: Identify Direct Vs. Shared Costs
Direct costs are clearly linked to a single function.
- Example 1: A program coordinator’s salary = Program Expense
- Example 2: Printing donor appeal letters = Fundraising Expense
Step 2: Determine a Reasonable Allocation Method
For shared costs, use a reasonable and consistent basis to divide expenses among functions.
Common allocation methods include:
- Time studies, certifications, or staff timesheets for salaries and benefits
- Square footage for rent, utilities, and occupancy costs
- Usage – number of calls, supplies used, or mailings sent)
- Other logical estimate of usage that is supported, documented, and revisited at least annually
Step 3: Determine When Allocations Will Occur
How often you perform allocations can vary depending on your accounting system, size, and reporting needs.
The key is to be consistent and ensure allocations are timely enough for accurate reporting and decision-making. The table below covers some common approaches:
| Timing | Description | When It’s Typically Used |
| Real-time (per transaction) | Each transaction is coded to the appropriate function at the time of entry. | Best for organizations with accounting systems that feature this capability (QuickBooks, Sage, etc.) clearly defined functions (i.e. more than one program operating and being presented). |
| Batch allocations (weekly or biweekly) | Expenses are recorded initially in general categories, then allocated in batches based on timesheets or usage data. | Useful for organizations tracking staff time or shared costs regularly. This can be done by pay period. |
| Monthly allocations | Indirect or shared costs (like rent, admin salaries, insurance) are allocated at month-end using consistent percentages or time study data. | Most common approach for nonprofits and grant-funded organizations; aligns with monthly financial reporting. |
| Quarterly or annual allocations | Allocations are done less frequently, often at year-end for audited financial statements. | Acceptable only if interim reporting doesn’t require functional detail or there is no federal funding present. |
Step 4: Document Your Methodology
Create a written cost allocation plan that describes each step above.
This should include:
- Which expenses are considered direct vs. shared
- The basis for each type of allocation – e.g. payroll by timesheet, occupancy by square footage, etc.
- When allocations will occur
- How often allocations will be revisited for potential changes
Allocating expenses by function, and, when appropriate, by cost center, is more than an accounting exercise; it’s a necessary aspect of financial integrity for nonprofits and federally funded organizations. A consistent, well-documented allocation process ensures compliance with IRS and federal grant requirements, paints a transparent picture of how resources are used, and empowers leadership to make informed decisions grounded in accurate data. Whether your organization tracks allocations in real time or processes them monthly, investing in the right systems and methodology will strengthen accountability, improve reporting, and ultimately help you demonstrate that every dollar is being used to advance your mission effectively.
