COST ALLOCATIONS

Part 2 – Management and General

In Part 1 of this two-part series we looked at the definition and purpose of cost allocations and the underlying general ledger (GL) structure that supports them. Now we will delve into Management and General (M&G), its role in financial reporting, and the techniques we use to account for it. (M&G can also be called “administrative overhead.”)

M&G is reported on the IRS 990 which is available to the public online (through the Guidestar database on the Candid website and on the IRS website), so it is a topic that needs to be handled with care.

Here are some examples of costs that are typically reported as M&G.

  • Human Resources
  • Payroll Processing
  • Finance and Accounting
  • Legal and CPA fees
  • Executive Director office
  • Board of Director expense
  • Information Technology
  • Corporate Compliance
  • Public Awareness (marketing)

Note that fundraising is not M&G – we will discuss the difference between the two below.

M&G is a collection of costs that benefit all programs and cannot appear as direct lines on program budgets and reports. You are unlikely to see a line item on a homeless shelter income statement called “executive director travel” or “board of director expense.”

When total M&G is allocated, each cost center gets a lump sum which represents its share of the organization’s M&G cost. Before seeing how this is done on a standard income statement, let’s see what M&G looks like on a functional expense statement as it would appear in Part IX of the 990 and in the audited financial statements.

In a previous essay we were introduced to the Twin Mountain Youth Symphony (TMYS) which operates a High School and a Middle School Orchestra (HSO and MSO). Their functional expense statement appears below. Note that this is not a complete income statement; revenues and net income are not included.

Here, Program, M&G, and Fundraising are displayed in separate columns with line-item detail and no allocation of M&G to the programs or to fundraising. (M&G is never allocated as a lump sum to fundraising). The functional expense statement allows the reader to calculate the M&G ratio: Total administrative costs compared to all other costs.

Total M&G $123,000

Divided by

Total Program expense before M&G plus fundraising expense $228,500

M&G Ratio 54%

54% is high by most standards. We will talk later about strategies for reducing this percentage.

Full Income Statements

The format of the 990-required functional expense statement provides the information that the public wants to see. Example 3a below is TMYS’s full income statement showing each program’s share of M&G costs along with revenues and net income. Management and board need to see full income statements for two primary reasons.

First: The full cost income statement shows each program’s contribution to M&G. This is crucial for decision-making. Consider a fictional $2 million nonprofit, NWS, that provides a food pantry along with an outreach program. Historically, both programs operate at breakeven after allocation of M&G. However, NWS’ food pantry has been notified that a $40,000 grant will not be renewed. NWS is therefore anticipating a deficit of $40,000 next year.

Without considering M&G, management decides to close the program on 12/ 31/20×1. In 20×2 all of the food pantry’s direct costs have been eliminated along with the donation revenue that helped to cover its M&G costs. In Example 2 Scenario A we can see what happens when the program is closed. Surprise! The fixed M&G cost does not go away, but the donation income that partially covered it does, so the outreach program’s M&G allocation has now increased by $60,000.

The exercise of allocating M&G provides critical information here. By reviewing scenario B, management and board can see that if the food pantry stays open, even with the loss of the grant revenue, it will generate enough donation revenue to cover part of the M&G allocation, and the organization-wide deficit will be $40,000 compared to $60,000. Unless NWS is prepared to cut M&G expense, the organization is worse off by $20,000 under scenario A. Perhaps it would be better to keep this mission-critical program open and develop a long-term strategy for reducing costs and/or increasing revenue.

Second: In a previous essay we saw that a successful grant application budget includes an expense allocation for M&G. Once the program is underway, grant income in the program cost center will include reimbursement for M&G at the rate approved in the grant. The income statement reader needs to know if the program’s share of actual M&G is higher or lower than the amount included in the grant revenue. If the nonprofit’s M&G ratio is 20%, but the grant pays only 10% it is imperative that management and board know that the program is running a deficit due to inadequate funding for administrative overhead. This information can only be seen if M&G is allocated to each program on its income statement according to the organization’s M&G ratio.

The Mechanics of Allocating M&G

I hope I have convinced you that M&G allocations are necessary, but despite everything I have said, not all nonprofits regularly allocate their M&G expense to the programs. Very small nonprofits may get a pass if they have no administrative staff or if their funding does not include grants for specific programs.

Now let’s go back and look at Twin Mountains Youth Symphony’s (TMYS) full income statement. You might be wondering how we can report M&G costs in their own column and also allocate them to the programs without double counting. Example 3a, below, shows how TMYS does this. On the line called “M&G Allocation” the lump sum total of $123,000 is moved to the two programs. But the individual costs in all columns have not been disturbed, so readers can have it both ways: They can see how efficiently administration carries out its activities, and they can see the full cost of operating the programs.

We can see in Example 3a that M&G has been spread to both programs in proportion to their total expense using the amounts calculated in Example 3b. Ideally your GL software has the ability to calculate the M&G allocations and create the journal entry that will populate the data on the line called “M&G allocation” in 3a. The journal entry employs a contra account (endnote 1) and is shown below in Example 4. TMYS’s GL software would probably not have that capability, however, so the CFO will have to manually calculate the allocation and enter the journal entry.

The debits and credit amounts in Example 4 can be found in Example 3b.

Defining Your True M&G activities

We noted above that TMYS has a frighteningly high M&G ratio of 54%. We know that funders and the public, all of whom have on-line access to TMYS’s functional expense statement on their 990, will disapprove.

But upon looking closely at its operations we may find that the ratio of administrative tasks to program tasks is not actually that high. TMYS’s executive director (ED) writes promotional material for both groups, reviews all the concert programs, takes calls from parents, and arranges outreach programs to the schools. All of these and many other tasks are program activities that should be reflected as direct expenses in the MSO and HSO cost centers.

Let’s say you determine that 50% of the ED’s time is spent equally on MSO and HSO. In example 3a M&G salaries/fringe are $100,000. With the new allocations, M&G salary/fringe will go down to $50,000, MSO and HSO salary/fringe will each increase to $75,000, and the M&G ratio will go down to 26%.

Fundraising and Public Awareness

Fundraising is a required column on the functional expense statement and is shown in Examples 1 and 3. Ours is a highly simplified example which assumes that TMYS relies almost entirely on grants and student fees for its revenues, spending only $500 to mail out an annual appeal letter to a list of 100 past or potential donors. (In reality, an annual appeal would involve far more expense for printing, database management, social media posting, etc.)

Fundraising always includes the salary and fringe benefits of any development personnel, and also the portion of the executive director’s (ED) salary that is devoted strictly to raising revenue: activities such as donor cultivation and asks, special events planning, or planned giving campaigns. When allocating the ED’s salary there is a clear distinction to be drawn between “fundraising” and “public awareness.” Program-related marketing activities such as annual reports, newsletters, and free public outreach events are examples of public awareness activities and are considered M&G.

In our example, TMYS’s executive director’s time spent on public awareness is reported in the M&G column, and their time spent on the annual appeal is so minimal that it is not necessary to allocate it to fundraising.

It is important to carefully identify the difference between fundraising and public awareness activities because the cost that is reported in the fundraising column will probably not be eligible for grant funding; although there are many exceptions, it is best to assume that fundraising expenses are expected to be covered by fundraising revenues.

M&G is Never Easy

I call M&G a conundrum because all nonprofits struggle to maintain a robust administrative infrastructure with their available funding. The M&G ratio is public and some funders have unrealistic ideas about what that should be. An organization should understand its M&G ratio and, when it is considered high, seek to explain the reasons to a potential funder in the early stages of the application process.

Whatever the ratio may be, CFOs need to be vigilant in assuring that M&G activities are properly classified, recorded, and reported in order to support board and management as they wrestle with the M&G problem.

Endnote 1

A contra account is a GL account used to add or subtract values to another account when the two are combined on a financial statement. Accumulated depreciation is a contra account; it is used to show an asset’s original value less depreciation on the balance sheet. We can see in Example 3a that the M&G contra account balance acts as a subtraction to total expense in the M&G cost center, and an addition to total expense in the program cost centers.