What are functional expenses and how do you allocate them?

The latest view on not-for-profit accounting issues

You may have heard the phrase functional expenses thrown around, and now I am here to help clarify what that means. First, to understand functional expenses for nonprofit organizations it is important to understand the difference between functional expenses and natural expenses. A natural expense category breaks out expenses by their expense type.

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This could include but is not limited to the following:

  • Salaries and wages
  • Rent
  • Utilities
  • Office supplies
  • Repairs + maintenance
  • Depreciation
  • Information technology

Now, that we know what a natural expense category is we can cover functional expenses. Functional expenses break out those natural expenses and show which portion is related to a certain “function”. Another way to look at it is allocating each natural expense based on what type of activity the expense is used for. Different activity types are programs, management and general, and fundraising. Program expenses include any costs incurred relating to the programs and services provided by the non-profit organization relating to the organization’s mission. Management and general expenses include supporting costs that do not relate directly to the organization’s mission. This can include costs for management, accounting, budgeting, and so on. Fundraising would include any costs used for soliciting contributions or grants.

Expenses can be either direct or indirect. Direct costs should be allocated directly to the functional category and indirect costs allocated based on some form of a reasonable allocation methodology. The two most common methodologies would be square footage allocation and employee time. Depending on the natural expense type, you would want to use the methodology that would be the most appropriate.

Square footage allocation is typically used for items such as building depreciation, rent, and utilities. To use this methodology, the organization will need to know the square footage of their physical locations and determine which areas relate to the corresponding function. Employee time can be based on employee headcount or time study to determine the amount of time each employee spends on a certain function. After salaries has been allocated, this same allocation can be applied to other natural expenses such as payroll tax and employee benefits. These allocation methodologies should be evaluated each year to make sure that they are still applicable and have been updated for any organizational changes.

It is important to remember these allocation methodologies are not limited to the natural expenses listed above and these are not the only methodologies available to your organization. When deciding how to allocate you will want to make sure you are making the choices best suited for your organization and that the reasoning behind those decisions is supported.

Please contact your Henry+Horne nonprofit adviser with any questions.

Tyler Croisdale