Functional Expense Allocation: How to Split Every Nonprofit Expense the Right Way

Sep 28

9 min read

The short answer: Functional expense allocation means assigning every expense to the function it supports: program services, management and general, or fundraising. Charge costs directly when they clearly belong to one function. Split shared costs, such as an executive director's salary, rent or IT, using a reasonable, documented basis like time records, square footage or headcount. GAAP requires every nonprofit to present expenses by both function and nature and to disclose its allocation methods (FASB ASU 2016-14). The same split feeds Part IX of the Form 990.

Most guides define the three categories and stop. This one walks through how to actually do it: a full worked allocation grid for a hypothetical $1.4M nonprofit, a simple time study method, a sample financial statement note, the rules on who counts as "program," and the mistakes auditors flag most often.

What GAAP and the IRS require

GAAP (ASC 958, as updated by ASU 2016-14)

Every nonprofit reporting under GAAP must:

Present expenses by both function and nature (salaries, rent, supplies and so on) in one place. That can be the face of the statement of activities, a separate statement or the notes (ASU 2016-14).
Disclose the method(s) used to allocate costs among program and support functions (ASU 2016-14).

ASU 2016-14 also added guidance that matters a lot for small organizations. When someone's work is direct conduct or direct supervision of a program or of fundraising, that portion of their cost belongs in that function, not in management and general. And costs that benefit several functions, such as information technology, generally should be allocated among them (ASC 958-720-45-2A, in ASU 2016-14).

The IRS (Form 990, Part IX)

Part IX of the Form 990, the Statement of Functional Expenses, has columns for Program services, Management and general, and Fundraising. Section 501(c)(3) and 501(c)(4) organizations must complete all of them. The IRS instructions say that if your accounting system doesn't allocate expenses, you can use any reasonable method, but you must document the method in your records (IRS Instructions for Form 990, Part IX).

We don't prepare or file 990s. We get the books and the allocation schedule ready and work with whoever files, so Part IX matches your financial statements.

The three functions, in plain English

Function	What belongs here	Examples
Program services	Activities that deliver your mission to the people you serve	Program staff, program supplies, the portion of the ED's time spent directly supervising programs, program facility space
Management and general	Oversight and running the organization as a whole	Board costs, accounting and audit, HR and benefits administration, general management, grant financial reporting
Fundraising	Asking for and cultivating contributions	Development staff, appeals, donor events, donor database costs, grant writing

Who counts as "program": the direct conduct test

The FASB's examples in ASC 958-720-55 (added by ASU 2016-14) are worth knowing:

CEO / Executive Director: time spent directly overseeing a program goes to that program. Time spent cultivating donors goes to fundraising. General oversight of the whole organization stays in management and general.
CFO / finance lead: accounting, budgeting and cash management are management and general.
HR department: benefits administration for everyone is management and general. It is not spread to programs.
Grant accountant: preparing a grant's financial report is an accounting function, so it's management and general. A program lead preparing a grant's program report is directly conducting the program.

This matters because small nonprofits often leave 100% of the ED in management and general. If the ED actually spends a third of their week running programs, that understates your program spending.

Direct vs. allocated costs

Direct charge first. If an expense clearly belongs to one function (food for the pantry, the audit fee, gala catering), code it there when you enter it. Directly coding expenses is the most accurate method and the easiest to defend.

Allocate the rest using a basis that reflects what drives the cost:

Shared cost	Common allocation basis
Salaries of people who work across functions	Time records or a documented time study
Benefits and payroll taxes	Same split as the related salaries
Rent, utilities, property insurance, building depreciation	Square footage used by each function
IT, software, phones, office supplies	Headcount or FTEs by function
General liability insurance	Square footage or total salaries (pick one and stay consistent)

One caution from practitioners: your financial statement functional allocation is not the same thing as a federal indirect cost rate. The cost pools and rules differ, so one doesn't automatically match the other (Yeo & Yeo, Functional Expense Allocation). Federal awards follow the Uniform Guidance. For example, organizations without a negotiated rate may elect a de minimis indirect rate of up to 15% of modified total direct costs (2 CFR 200.414(f)).

How to run a simple time study

Time is usually the biggest allocated cost, so it needs the most support.

Pick the people. Anyone whose job crosses functions, usually the ED, an operations or admin role, and sometimes program directors who also fundraise.
Pick representative periods. Daily time tracking all year is the strongest support. If that isn't practical, track at least two separate representative periods of two weeks or more during the year, and avoid unusual weeks (the week before your gala isn't typical).
Track by function, and by program if you have several. Fifteen-minute increments are plenty.
Summarize into percentages, and have each employee and their supervisor sign off.
Apply the percentages to salaries and the related benefits and payroll taxes.
Redo it at least annually, and whenever someone's role changes.

If you have federal awards: salary charges to federal awards must be based on records that accurately reflect the work performed and that are supported by a system of internal control (2 CFR 200.430(g)). That's a higher standard than an annual snapshot for anyone charged to a federal grant, so talk with your CPA about what your awards require.

Worked example: a full allocation for a $1.4M nonprofit (hypothetical)

All numbers are hypothetical, for illustration only.

A food-access nonprofit has $1,436,000 in total expenses.

Step 1: The time study

Position	Salary	Program	Mgmt & general	Fundraising
Executive director	120,000	30%	50%	20%
Program director	85,000	100%	—	—
Program staff (8)	440,000	100%	—	—
Development director	75,000	—	—	100%
Finance & operations manager	70,000	—	100%	—
Office coordinator	30,000	30%	50%	20%
Total salaries	820,000	570,000	145,000	105,000

Step 2: The other allocation bases

Square footage (6,000 sq ft total): pantry and warehouse 4,800 (80%) to program; admin offices 960 (16%) to management and general; development office 240 (4%) to fundraising. Common areas were assigned proportionally.
FTEs by function (13 people, split using the time study): program 9.6, management and general 2.0, fundraising 1.4.

Step 3: The grid (expenses by nature and function)

Natural expense	Basis	Program	Mgmt & general	Fundraising	Total
Salaries	Time study	570,000	145,000	105,000	820,000
Benefits & payroll taxes	Salary split	114,000	29,000	21,000	164,000
Rent	Sq ft	76,800	15,360	3,840	96,000
Insurance	Sq ft	17,600	3,520	880	22,000
IT & software	FTEs	17,723	3,692	2,585	24,000
Office supplies	FTEs	6,646	1,385	969	9,000
Food & program supplies	Direct	210,000	—	—	210,000
Depreciation (delivery vans)	Direct	30,000	—	—	30,000
Printing & postage	Direct	3,000	—	12,000	15,000
Donor event costs	Direct	—	—	18,000	18,000
Audit & accounting fees	Direct	—	28,000	—	28,000
Total		1,045,769	225,957	164,274	1,436,000
% of total (rounded)		72.8%	15.7%	11.4%

Notes on the judgment calls:

$36,000 of the ED's salary (30%) is program, because the time study shows direct supervision of the pantry. Leaving 100% of it in management and general would have understated program spending.
Printing and postage: $3,000 of program flyers is program. The $12,000 for donor appeals is fundraising. The appeals include some education about food insecurity, but they don't meet all three joint-cost criteria (purpose, audience and content), so 100% stays in fundraising (Give.org , Joint Cost Allocation).
Benefits follow salaries, so there's no separate study needed.

Step 4: The sample note disclosure

Note X: Allocation of functional expenses. The costs of providing programs and other activities have been summarized on a functional basis in the statement of functional expenses. Expenses directly attributable to a function are charged to that function. Certain categories of expenses are attributable to more than one function and are allocated on a reasonable and consistent basis. Salaries, benefits and payroll taxes are allocated on the basis of time and effort studies. Rent and insurance are allocated on the basis of square footage. Information technology and office supplies are allocated on the basis of full-time equivalent employees by function.

Adapt it to your actual methods. The note has to describe what you really did.

Step by step: setting up allocation in your books

Write a one-page cost allocation policy. List each natural expense, its basis, the data source and how often it's updated.
Set up the coding. In QuickBooks, use classes for functions (and programs). In Sage Intacct, use dimensions. Aplos supports fund and functional tracking. Code direct costs at entry.
Gather the allocation data: the time study, square footage and FTEs.
Allocate monthly or quarterly with one consistent journal entry from a shared class into the functions, not at year-end in a rush.
Review the grid for anything odd: travel in a program with no travel, fundraising costs with no events, management and general above what makes sense.
Reconcile the grid's total to total expenses on the statement of activities.
Hand the grid to your auditor and 990 preparer, together with the policy and the support.

Functional expense allocation checklist

[ ] A written allocation policy, approved by the finance committee or board
[ ] Direct costs coded to a function at entry
[ ] A current time study for everyone who works across functions, signed off
[ ] ED time split based on the direct conduct / direct supervision test
[ ] Benefits and payroll taxes follow the salary split
[ ] Square footage measured and documented (including any changes during the year)
[ ] FTE or headcount basis updated for staffing changes
[ ] Joint costs (mixed appeal and education materials) evaluated against purpose, audience and content
[ ] The grid shows every natural expense line by function, not one "indirect costs" line
[ ] The grid ties to total expenses
[ ] Note disclosure drafted to match actual methods
[ ] Part IX inputs provided to the 990 preparer from the same grid
[ ] Federal award salary charges supported under 2 CFR 200.430(g), if applicable

Common mistakes

Putting 100% of the ED in management and general when they directly run programs or cultivate donors.
Spreading HR or accounting into programs. Those are management and general under the FASB examples.
Using one percentage for everything. Each type of cost should follow its own driver.
Doing the allocation once, at year-end, from memory. It's hard to support and easy to get wrong.
Allocating appeal mailings to program without meeting the joint-cost criteria.
Collapsing the grid into a single "indirect costs" row. GAAP requires each natural expense category to be broken out by function (Yeo & Yeo).
Assuming your federal indirect rate equals your management and general percentage. They're different calculations.
Changing methods every year without a reason. That makes the trend meaningless. If you change, document why and talk with your auditor first, because a change in allocation method raises consistency questions in the audit.

When to bring in a CPA

Bring in a CPA-led accounting team when:

Your functional split is a guess, or is the same percentages you've used for years
You're preparing for your first audit, or your auditor adjusted functional expenses last year
You have federal awards, and time and effort documentation is coming up
Your board or a funder is asking about your program ratio and you're not confident in the number
Your Part IX and your financial statements don't agree

We'll write the allocation policy with you, set up the coding, run the time study, book the allocation monthly, and give your auditor and 990 preparer a grid that ties.

FAQ

What is functional expense allocation?

It's assigning each nonprofit expense to program services, management and general, or fundraising. Expenses that clearly belong to one function are charged directly. Shared costs are split using a reasonable, documented basis.

Is a statement of functional expenses required?

Under GAAP, every nonprofit must present an analysis of expenses by both nature and function in one location: on the statement of activities, as a separate statement or in the notes. It must also disclose its allocation methods. Form 990 filers also report functional expenses in Part IX.

How do you allocate an executive director's salary?

Use a time study. Time spent directly supervising programs goes to program, time cultivating donors goes to fundraising, and general oversight stays in management and general.

What's the best way to allocate rent?

Square footage is the most common basis. Measure the space each function uses, assign shared space proportionally, and document it.

Is grant reporting a program cost or management and general?

Financial reporting on a grant is management and general, because it's an accounting function. A program report prepared by the person running the program is part of conducting the program.

Does our functional allocation have to match our federal indirect cost rate?

No. They're built under different rules for different purposes. Keep them consistent with each other where you can, but don't assume they'll match.

Want a second opinion on your program ratio?

Our Free Financial Checkup is a 30-minute call with a CPA. We'll look at how you're allocating expenses today, whether it would hold up in an audit, and what we'd change. Honest next steps, no pressure.

This article is general information, not legal or tax advice. Talk with your CPA about your organization's specific situation.