COST ALLOCATIONS

Part 1 – Allocating Costs in the General Ledger

If the general ledger (GL) is an edifice, its foundation is the IRS 990 and its architect is the CFO.

“Why is a nonprofit’s financial structure driven by an IRS form?” you ask. “Nonprofits don’t even pay taxes!” True, but nonprofits are granted their tax exemption by the IRS and are responsible for reporting to the IRS annually via the 990. The 990 is designed to answer the public’s questions about how nonprofits use the dollars entrusted to them. All 501(c)(3) organizations with revenues of $200,000 and above must break down their expenses between the functions of “Program Service,” “Management and General” (or M&G), and “Fundraising” on the 990 Part IX, “Statement of Functional Expenses.” This report is also required in the annual audit report.

As the architect of the GL, you create the infrastructure that will yield income statement reports for a wide range of purposes, including the functional expense statement. The structure will always be based on accounts and cost centers and sometimes other dimensions. Each of your programs will be attached to a unique cost center or a group of cost centers depending on the complexity of the program’s funding. Our job here is to look at the decisions that go into assigning revenue and expense transactions to the correct cost centers.

Shared Costs Defined

There are times when processing an invoice for, say, copy paper, is easy. The person who purchased the paper tells the business office which program (or cost center) it was for and presto, the expense is recorded in the GL with no fuss.

But a single cost center cannot always be identified. Let’s consider a fictional youth music program called the Twin Mountains Youth Symphony (TMYS) which operates a middle school orchestra (MSO) and a high school orchestra (HSO). Music purchases and instrument repairs are easily charged to MSO and HSO – we call these “direct” costs. But the music director conducts both orchestras. Their salary and fringe benefits are not direct because they are shared between the two cost centers. The same is true for rehearsal space rental and printing of programs for joint concerts.

(We are discussing shared costs here. For definitions of direct versus indirect costs in the context of a grant application see https://blueavocado.org/finance/grant-application/)

The Search for the Best Method for Allocating Shared Costs

What percentage of a shared cost should be charged to MSO and HSO? The CFO needs to find a practical and appropriate basis for allocation. We are looking for a characteristic that will measure the relative amount of benefit each derives from the expense. TMYS could use number of participants as a basis for allocation; a larger organization might use the number of full-time equivalent (FTE) staff employed in each program.

But we don’t always look to program size as the basis of allocation. In TMYS’s case, the number of students appears to be the most objective basis, but what if the middle school students need significantly more of the music director’s time—extra coaching, behavior problems, maintaining instruments, talking with parents, etc.? “Time spent” might be the better basis of allocation. While music and rehearsal space might be split 50/50, the music director’s salary and fringe might be 75/25.

Time spent is an acceptable basis for allocation, but since it is perceived as more subjective than other methods, documentation is particularly important. In TMYS’s case a memo to the file laying out in detail your reasoning (based on conversations with the director) will probably suffice. Government and other funders can have stringent rules for documentation of time spent, however; be sure to check the contract and any guidance provided by the funding entity.

The gold standard for allocating shared costs is usage and this should be your basis of allocation whenever it can be practically identified. Sometimes the vendor can do the work for you. If you have contracts for services used by multiple cost centers, your vendors might be capable of identifying the cost centers on the bill. A lawn care bill for a group of residences should show the individual addresses on the invoice. A cell phone vendor should be able to identify the cost center for each phone. A postage machine or a copy machine might require a code to be entered whenever it is used.

Shared office space often requires cost allocation; a medium-sized nonprofit with a variety of programs will probably have many programs housed in the same building. Conventional wisdom says that property costs such as rent, utilities, security, etc., should be allocated based on square footage. But after many years of wrestling with tape measures and floor plans and allocating hallways, bathrooms, and conference rooms, I switched to FTEs—an acceptable basis of allocation. When a building is used exclusively for offices there is often a reliable correlation between the number of staff in each program and the amount of space used.

Some Practical Considerations

We have seen that the everyday labor of assigning the correct amount of revenue and expense to the correct cost center is not simple at all. We have identified some principles to follow when expenses are shared between cost centers:

  • The basis of allocation must be a measure of the relative benefit each cost center receives.
  • The basis of allocation must be reasonable, logical and well-documented.
  • The most objective method should be chosen whenever possible.

But here is another principle: Allocation methods must be practical and take materiality into account. Materiality is concerned with the amount of impact a transaction will have on the financial statements. Materiality drives our decisions about where to concentrate our efforts. While usage is the most objective basis for allocating vehicle fuel, your business office staff could spend many hours poring over vehicle logs to identify which staff used which gallons of gas for which programs. The same goes for postage and copy machine reports. Perhaps your staff can save precious time by analyzing, say, the copy machine report once or twice a year to derive recurring allocation percentages. You might be able to estimate vehicle usage percentages by interviewing program management staff. The difference in results between “super accurate” and “accurate enough” may be so small that it is advisable to go with the method that saves time.

Materiality is a concept that auditors live by. The auditors and the readers of financial statements want to see information that fairly represents your organization’s financial position at a given point in time. As we know, meeting this goal is easier said than done. Staff time must be used efficiently. I’m going to go out on a limb and say that, given that time is a precious resource, your auditors will not complain if they find a few instances where a bill for $3.50 was charged to the largest of five programs in the group rather than spread manually to all five.

Health Insurance: A Special Case

Health insurance cost is one of the largest expenses in the budget, and the cost associated with each employee can be identified, so it should follow that the effort required to identify and charge each employee’s cost to their cost center is warranted.

But health insurance carries with it ethical considerations which, I believe, take top priority in selecting the basis for allocation. The cost of health insurance varies widely depending on the employee’s choice of plan, and the organization is legally prohibited from exerting any influence over the choices made. The program managers, therefore, should have no ability to make personnel-related decisions based on health insurance, and, as a corollary, they should not be held responsible for a cost they do not control. If health insurance cost is bringing programs down, it is executive management’s job to find ways to reduce health insurance for the entire organization.

I would argue, therefore, that all cost centers should share the cost of health insurance according to a logical basis of allocation. I recommend that the expense be distributed to each cost center proportionately based on the number of FTEs eligible for insurance—a method accepted by funders and auditors.

For the same reasons, I also prefer using an average amount for health insurance in the annual budget and grant budgets. There is no way to guess the health insurance choices that new hires will make, or how current employees’ health insurance needs may change during the course of a year. I recommend, therefore, that a fixed, average cost be assigned to each FTE in the budget.

Here is an example that illustrates the mechanics that a fictional nonprofit would use to allocate actual and budgeted health insurance cost.

The Ethics of Cost Allocations

Why is cost allocation so tricky and so important?

First: Nonprofit funding is often based on cost reimbursement. The costs that you accumulate in your grant-funded cost centers will go on your request for payment. The amounts that have been assigned to the cost center either as direct costs or allocations of shared costs represent the payments that you will receive if your request is approved. If your health insurance allocations, for example, are way off, the affected programs will receive either more or less funding than they are entitled to.

Second: The financial reports that you pull from your GL are a critical tool for decision-making. Changes in the proportion of shared costs allocated to each program can have a major impact on the reported financial health of individual programs. Board and management need the most accurate information possible to evaluate the success of each program.

The most valuable advice that I can give regarding cost allocations is to step back and picture yourself justifying your choices to an auditor a year down the road. Ask yourself these questions: If I was the funder or an auditor, would I deem this allocation method to be fair and reasonable? Have I fallen into the trap of loading too much expense into a more richly funded program simply to maximize my revenue? Is my documentation clear and easy to follow?

Programs come and go but your integrity must endure. Make sure that the decisions you make in the heat of the moment will hold up over time.

Cost Allocations Test the Mettle of the CFO

As the architect of your GL, you will, at times, find cost allocations to be challenging. You will be called on to make decisions that affect the financial reports and possibly funding. You have some flexibility in your choices, but they must always be reasonable and logical. funding. Cost allocation decisions always require judgment, a strong ethical compass, and excellent documentation.