Best Practices for Functional Expense Allocations in Not-for-Profits

Accurate functional expense reporting helps organizations build trust and support mission-driven decision making

Functional expense allocations are a vital component of financial reporting for not-for-profit organizations. Proper allocation and documentation of expenses ensure transparency, compliance with accounting standards, and provide donors with confidence in the organization’s utilization of donations.

Understanding functional expense allocations

Functional expense allocation involves categorizing expenses according to their purpose. Not-for-profit organizations primarily focus on program service expenses, which are any expenses incurred that directly support the mission. However, supporting activities, such as management and general activities, fundraising activities and membership development activities are essential to ensure that program services can function. Not-for-profit organizations face unique challenges, as their operations are often complex enough to require careful tracking but may not have the staffing support to closely monitor every transaction while still focusing on their mission. Accurate allocation is essential for compliance with generally accepted accounting principles (GAAP) and for presenting a clear picture of organizational activities to donors, regulators, and board members.

Program activities

Ideally, your non-profit organization’s total expenses will be made up primarily by program activities. Program activities are the direct services and mission-driven work your organization performs to achieve its stated purpose. These expenses are tied to specific programs and typically include costs such as staff time spent directly serving the organization’s mission, program supplies and materials and participant support. Examples of program activities vary significantly based on your organization’s mission. An animal shelter’s program expenses could include food, utility costs for the shelter, or veterinary costs. A tutoring organization might include program expenses such as textbooks, computer software access, or salaries paid to tutors. All program activity expenses should directly serve the organization’s mission.

Non-program activities

Although achieving the mission of your non-profit organization is the main goal, it cannot be done without incurring costs behind the scenes. There are three broad types of expenses that might be included within the non-program functional expense allocation:

• Management and general expenses: These expenses include organization-wide leadership and oversight that support the mission but are not tied to a specific program. Examples include board support (maintaining board minutes), strategic planning, finance and accounting (month-end close, budgeting, audit preparation, financial reporting), human resources (recruiting, onboarding, payroll, and benefits administration), legal and compliance (contract review, insurance, and regulatory filings), and general office operations such as IT support, rent and utilities for shared administrative space, and administrative supplies.
• Fundraising expenses: These expenses involve any efforts that are made to receive grants, contributions and sponsorships from donors. Examples include planning and running an annual appeal, donor prospecting and cultivation, grant research and proposal writing, stewardship activities like donor acknowledgements and impact updates that are primarily intended to support future giving, and fundraising events (venue deposits, catering, event marketing, and payment processing fees). For more complex organizations, fundraising may also include the cost of maintaining donor databases/CRM systems or hiring outside consultants for campaign strategies.
• Membership development: These expenses include recruiting, renewing, and servicing members when an organization has a formal membership base. Examples of costs associated with membership development include producing membership materials (welcome packets, renewal notices, member newsletters), managing member records, processing dues, running member drives, and providing member services and communications (help desk inquiries, member-only webinars, and benefits fulfillment).

Essential documentation to retain

The foundation of functional expense allocation is strong documentation. Organizations should retain:

• Invoices and receipts: Keep all invoices and receipts related to expenses, ensuring they clearly indicate the nature of the goods or services and their intended use.
• Employee timesheets: For organizations with a lower staff count, it is common for each employee to perform work related to multiple activities. To aid in creating an allocation for salary expense, maintain detailed timesheets that document hours spent on different functions, such as program work, administrative tasks, and fundraising activities.
• Allocation methodologies: Document the rationale and methods used for allocating shared expenses, including formulas or percentages and supporting calculations. Should this information change year-over-year, ensure that your documentation is updated.
• Contracts and agreements: Retain contracts and agreements that clarify the scope of work and help justify expense categorization.
• Board minutes and policies: Keep records of board meetings where allocation policies are discussed and approved, as well as written policies outlining allocation procedures.

Strategies for maintaining documentation

Maintaining functional expense documentation should be an ongoing process, not a last-minute scramble. Consider these strategies:

• Implement digital recordkeeping: Use accounting software or cloud-based document management systems to store and organize records. This allows your records to be easily accessible and stay top of mind throughout the year.
• Regular internal reviews: Schedule periodic reviews of expense allocations and supporting documentation. This proactive approach helps catch inconsistencies early and ensures records are up to date. Ensure that this is regularly communicated with the board.
• Establish clear policies: Develop written policies for expense allocation and documentation. Regularly update these policies to reflect changes in operations or regulatory requirements.

Conclusion

Functional expense allocations can be much more than a compliance requirement for not-for-profit organizations. They can also provide meaningful insight into how your organization’s expenses are actually being used. By retaining comprehensive documentation and employing effective strategies for maintaining records, organizations can streamline audits, enhance stakeholder trust, and support their mission with confidence.

If you have questions or would like additional guidance, contact your Keiter Opportunity Advisor | Email | Call: 804.747.0000.

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