In the nonprofit world, few topics can be as intimidating and daunting as cost allocation systems. Developing a complicated cost allocation plan might be somewhat difficult, but the basic concepts are actually quite straightforward! The worst approach nonprofit accountants can take is to ignore the fundamental points of cost allocation out of dread or fear.
Nonprofit organizations need to understand and properly account for the costs they incur. Functional expense classifications tell why an expense was incurred. Natural expense classifications tell what was incurred.
Per Generally Accepting Accounting Principles, there are four classes of functional expenses for nonprofit organizations: program services, management and general, fundraising, and membership development (uncommon for most nonprofits). The last three categories are known as “supporting activities”.
Direct versus indirect costs
- Direct costs are clearly identified with, or directly related to, a single objective or purpose.
They should be directly assigned a functional category; no actual allocation is involved.
- Indirect costs cannot be clearly identified with, or directly related to, a single objective or purpose. These costs need to be allocated to the appropriate functions.
Here’s a very important distinction: indirect costs are NOT the same as supporting activities. Rent is an indirect cost, but it can be allocated to the program services function. On the other hand, accounting is a direct cost, but it is usually assigned to the management and general category (a supporting activity).
Allocation of indirect costs
So those costs that cannot be directly identified with a specific functional purpose – the “indirect costs” – need to be allocated to the various functions. The basic questions to consider for allocation of indirect costs are what was the PURPOSE of the cost? And what CAUSED the cost to be incurred? These questions help us determine logical cause and effect relationships between the indirect cost and the expense functions.
- One common causal factor is staff time. This is especially relevant for allocating indirect personnel costs. Estimates of time that certain staff devote to the various functional categories can be developed, and this can serve as the basis – the “cost driver” – for allocating indirect personnel costs. Other indirect costs might also be assigned to this cost driver.
- Another common causal factor is space or area. This is especially relevant for allocating indirect occupancy costs. Relative amounts of square footage in the areas where certain functional activities occur can be calculated, and this can serve as the cost driver for allocating indirect occupancy costs. Other indirect costs might also be assigned to this cost driver.
Cost allocation on the 990
All 501(c)(3) and (c)(4) nonprofits must allocate expenses to functions in Part IX of the 990 informational return. Generally, the cost allocation system used in the organization’s accounting system can serve as the basis of allocations for 990 purposes. However, there are a few important points to consider:
- Only three categories of expenses are present on the 990: program, management and general, and fundraising. So if a nonprofit has any expenses assigned to membership development in its financial statements, it needs to determine a reasonable way of allocating those to the other three categories.
- Primary natural expense categories have been pre-set by the IRS. Some rearranging of expense categories to transform the natural expenses in the financial statements to the expense categories of the 990 might be required.
- Some expenses should be removed for functional reporting purposes, and placed on different parts of the 990:
- Rental expenses (that are associated with rental income activities)
- Costs of inventory sold
- Direct expenses of fundraising events
- Gaming expenses
Any cost allocation method can work and pass muster if it’s rational, consistently applied, and documented. An organization does not need to worry about developing the one true and correct allocation system for its situation because for most nonprofits this simply doesn’t exist. The system implemented just needs to be reasonable!