Five Minutes For Finance - Cost Allocations
Understanding Cost Allocations for Nonprofit Organizations
Our previous article covering administrative costs and indirect costs introduced the concept of costs that are difficult to attribute to specific departments or programs within a nonprofit organization. In this type of situation, the organization will need to spread the costs across multiple departments and programs. This applies to staff costs, especially when one must consider both departments and programs as well as funding sources.
Cost allocation is a crucial aspect of nonprofit financial management. It ensures that organizations accurately account for the costs of delivering programs and services, complying with funding requirements, and maintaining financial transparency. Unlike for-profit entities that focus on profitability, nonprofits must demonstrate accountability to donors, grantmakers, regulators, and the communities they serve. Effective cost allocation helps achieve this by fairly distributing expenses across various activities and funding sources.
What Is Cost Allocation?
Cost allocation is the process of identifying, aggregating, and assigning costs to different programs, projects, or departments within an organization. In a nonprofit setting, this typically involves dividing shared or indirect costs—such as rent, utilities, and administrative salaries—among the various programs that benefit from them.
Types of Costs
Before implementing a cost allocation method, it's important to distinguish between different types of costs:
Direct Costs: These are expenses that can be specifically identified with a particular program or activity. Examples include salaries of program staff, supplies used in program delivery, and travel for specific projects.
Indirect Shared Costs: Also known as overhead, these are expenses that support the organization as a whole and are not easily linked to a specific program. Examples include office rent, liability insurance, general office supplies, and janitorial services..
Administrative Costs: A subset of indirect costs, these are expenses specifically related to governance, finance, legal, and human resources activities. Examples include the salaries of the Finance team, costs for Board meetings, the annual audit, and the human resources information system.
Why Cost Allocation Matters
Grant Compliance: Many funders require clear reporting of how funds are used. Proper cost allocation ensures compliance with grant terms and conditions.
True Cost Recovery: Understanding the full cost of delivering a program allows nonprofits to seek sufficient funding and avoid underfunding.
Financial Transparency: Accurate allocation fosters trust among stakeholders and improves the quality of financial statements.
Informed Decision-Making: Leadership can make better decisions when they understand the financial performance and sustainability of individual programs.
Common Cost Allocation Methods
Percentage of Direct Costs: Indirect costs are allocated based on the proportion of total direct costs attributed to each program. For example, if Program A accounts for 60% of direct costs, it receives 60% of indirect costs. If a program’s activity involves a large amount of pass-through or subcontractor expenses, these expenses may be excluded or capped in the allocation calculator to reflect the actual consumption of indirect shared resources.
Full-Time Equivalent (FTE) Allocation: Indirect costs are distributed based on the number of full-time equivalent employees working in each program. The FTE of a full-time person is 1.0 and the FTE of a person that works half-time is 0.5. This is the most frequently used method of allocation as it avoids the potential distortions of other methods.
Usage-Based Allocation: Costs are assigned based on actual usage. For example, if one department uses 70% of a shared service (like IT), it absorbs 70% of the related cost. The organization should consider the cost of collecting usage data, as it may outweigh the utility of this methodology.
Square Footage: Facility-related costs (like rent and utilities) are often allocated based on the square footage used by each program or department. For organizations that frequently reorganize, or have limited ability to optimally configure their office space, this method may be difficult to maintain or justify.
Best Practices for Cost Allocation
Develop a Written Policy: Establish and document a formal cost allocation policy to ensure consistency and transparency.
Use Reliable Data: Base allocations on accurate and up-to-date information, such as time sheets, usage logs, or financial reports.
Review Regularly: Periodically review your allocation methods to ensure they still reflect actual resource usage.
Train Staff: Ensure that relevant personnel understand the importance of cost allocation and how to track relevant data.
Leverage Technology: Use accounting software with cost tracking and reporting features to streamline the process.
Challenges and Considerations
Nonprofits often struggle with balancing the need for accurate cost allocation with limited resources. Overly complex systems can be time-consuming and confusing. On the other hand, oversimplified methods might lead to inaccurate financial reporting or noncompliance with funder requirements. Finding the right balance requires understanding both the organization’s operational structure and the expectations of stakeholders.
Conclusion
Effective cost allocation is more than an accounting exercise—it’s a strategic tool that empowers nonprofit organizations to demonstrate accountability, secure adequate funding, and make data-informed decisions. By understanding and implementing best practices, nonprofits can enhance their financial health and ensure that resources are used efficiently in pursuit of their mission.
About this Series
Subsequent articles in this series will cover other topics related to nonprofit financial management. Here is a list of, with links to, previous articles:
About the Author
For over 30 years, Robert Pascual has been a leader in nonprofit financial management as a CFO, consultant, conference speaker and educator. He holds an MBA from the Haas School of Business at the University of California and is the founder and principal of Robert Pascual, MBA LLC. He has worked with small, mid-size, and large nonprofit organizations spanning the fields of education, workforce development, housing, health, philanthropy, social services, media, fiscal sponsorship, nature, and the environment. Each of these organizations has faced both unique and common challenges, some of which are probably similar to ones that you wrestle with.