A significant challenge facing many nonprofit organizations involves determining how much of their resources and expenses go toward each of their programs. Nonprofits do not necessarily see returns on investment in the same way as for-profit businesses, so they must find other means for tracking the sustainability of their operations. Cost allocation is a method of categorizing expenses or grouping them for each of an organization’s programs. This can be straightforward when it comes to costs that are directly related to specific initiatives. Other costs, such as overhead, present a challenge since they cover more general purposes for an organization. Several methods are available to help nonprofit organizations allocate these types of costs. Read on to learn more about them.
Why is Cost Allocation Necessary?
Cost allocation is a critical process that nonprofit organizations must undertake for various reasons. One of the most significant is the need to report to donors on the organization’s efficient use of funds. In this context, cost allocation helps ensure that donors can track their contributions’ impact and ascertain whether they are being appropriately utilized to support specific initiatives. Additionally, if a nonprofit receives grant money, it will likely have to provide regular financial reports to the grant organization. Cost allocation enables nonprofit organizations to provide detailed reports that break down the expenditure of the funds in a transparent and organized manner.
Another key reason why cost allocation is vital for nonprofit organizations is that it is often necessary for regulatory compliance. For instance, completing Form 990, a tax document that tax-exempt organizations file with the Internal Revenue Service (IRS), requires information obtained from allocating costs. Such documentation is crucial for nonprofit organizations to maintain their tax-exempt status and avoid penalties that may arise from noncompliance.
What Types of Costs Should an Organization Allocate?
Nonprofit organizations should strive to undertake a comprehensive cost allocation process to ensure that their resources and expenses are effectively distributed across their various programs. Implementing appropriate methods, as described in this article, can help nonprofit organizations allocate nearly every type of expense that they incur. The following categorization of expenses can help:
Direct vs. Indirect Costs
The biggest challenge in cost allocation involves costs that are not directly tied to particular programs or activities. “Direct costs” have a direct relationship to an initiative, so their allocation is a straightforward matter. Examples of direct costs might involve a separate marketing campaign for a program or expenses associated with an event in support of that program.
Indirect costs may benefit more than one program or the organization as a whole. Overhead costs, such as rent for an office and utilities, benefit all of an organization’s programs by providing the staff with a comfortable place to work. An organization’s website might constitute a single expense that supports multiple programs. Payroll expenses can benefit some or all programs, depending on each employee’s job duties.
Expenses directly associated with payroll are relatively easy to allocate. This includes salary, benefits, and related costs. An organization that tracks how its employees spend their time can use that data to help allocate payroll costs.
Non-personnel costs represent a critical expense for nonprofit organizations, and allocating such costs can present a significant challenge. These expenses, which include indirect non-personnel costs such as overhead expenses and general insurance coverage, are more difficult to allocate, making the methods outlined below all the more important.
Costs associated with specific grants can also present additional challenges when it comes to cost allocation. Nonprofit organizations must account for the use of grant funds in ways that align with the grant requirements while ensuring that cost allocation remains consistent across all programs.
What Methods Can Organizations Use to Allocate Costs?
To overcome these challenges, nonprofit organizations can use various methods for cost allocation. These methods can be applied to allocate indirect costs, including non-personnel costs and personnel costs that cannot be allocated to a specific project.
Per Employee Hour
Also known as the full-time equivalent (FTE) method, this allocates indirect costs using the same proportions as employees’ time records. It would use proportions based on all employee records over the length of the organization’s reporting period, such as a month or quarter.
Per Dollar of Salary
This method would allocate indirect expenses based on the proportion of personnel costs allocated to each project over the month or quarter.
Per Square Foot
This method could work for organizations that have dedicated space for different projects. The allocation would be based on the percentage of total square footage used by each project.
The number of employees involved in each project would determine the allocation using this method. Each project would be allocated in proportion to its number of employees.
Cost allocation is a critical process for nonprofit organizations that allows them to track the sustainability of their operations and report to donors and regulatory agencies. By implementing appropriate cost allocation methods, nonprofits can ensure that their resources and expenses are effectively distributed across their programs, enabling them to achieve their mission and maximize their impact.
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