A Nonprofit's Guide to Cost Allocations

7/19/2022 - By Emily Lalas

What is cost allocation?

Cost allocation for nonprofits is the practice of grouping all costs together in a manner that helps the user determine the actual cost of operating its programs and/or locations. To effectively develop and operate sustainable programs, nonprofit organizations should ensure that they are tracking and planning for the actual cost of each program. Many costs are easy to categorize by program. However, costs related to multiple programs such as management salaries, utilities and other shared costs may not be as easy to record directly to a program. As such, these costs are often overlooked when planning program funding, which can result in your organization not raising enough support to sustain operations or leaving funding on the table from awards that your organization has already received.

Donors use reports such as financial statements and Form 990 when evaluating an organization. One of the key pieces of information they are usually looking for is the percentage of an organization’s costs that are related to operating its programs as opposed to administrative costs. Additionally, they want to see that the cost of fundraising is generating a good return for the organization. Organizations typically want to keep the ratio of program costs to administrative costs as high as possible. Developing a strategic cost allocation plan can help organizations ensure that they are communicating the actual cost of operating their programs to users of their financial reports.

How should my organization determine a cost allocation plan?

While there are many ways to determine a cost allocation plan for your organization, it is best to keep it clear and simple. The following steps are recommended to complete your allocation plan.

  1. Take inventory of programs. The leadership team of your organization should meet to look at all the different services that the organization is providing to the community and should then determine significant programs. For example, you may provide food to the homeless that you fund with multiple grants each year. Instead of treating each grant as a program, consider treating the service itself as a single program, which is then funded with multiple grants. It is important to remember that the goal here is to capture the actual cost of the services you are providing, not necessarily the expenses reimbursed by a single grant.
  2. Determine direct program costs. These costs are anything that you can readily determine are related to a single program. For example, paying a teacher’s salary for an educational program or paying a food vendor for a meal service program. 
  3. Determine major indirect cost pools. Group costs for similar functions together to be allocated lump sum. For example, you may group together things like administrative salaries, fringe benefits, occupancy, marketing, general and administrative, etc. 
  4. Evaluate each program’s fair share of each cost pool. Evaluate each cost pool and determine the percentage of costs that go towards each program, then allocate the full amount proportionately. It is important to note that the portion of each cost pool benefiting particular programs may vary. For example, it may be determined that programs benefit from 90% of the total occupancy costs, but only 60% of total salary expense. To have a strong methodology, each cost pool should be evaluated based on an appropriate basis. This may include square footage for occupancy costs, direct costs of Program A in proportion to total direct program costs, etc. If you do not know where to start with allocating certain costs, the best thing to do is to evaluate any historical data that you have. This may include records such as timesheets of management personnel detailing how much time they spent on each program. Any costs left over after allocation to all programs and fundraising are considered administrative costs. 
  5. Document and use consistently. One of the most important things that you need to do after you develop a cost allocation methodology is to document the plan including your programs, cost pools, which accounts comprise each cost pool and the basis (or rationale) for allocating each cost pool. Organizations should allocate costs consistently in accordance with the established methodology. 
  6. Revisit and revise. As your organization evolves, it is important to reevaluate your costs and ensure that your cost allocation methodology is evolving alongside your actual activities. This may include changing the way that your costs are allocated to ensure that your organization continues to track the actual cost of each program. Any changes to the methodology throughout the year should be documented with a rational reason for doing so.

What if my organization receives grants with specific cost allocation rules?

Sometimes grantors determine the extent to which indirect costs can be charged to a specific grant. In this case, indirect costs may need to be recalculated for grant reporting and funding requests to abide by the terms of the awarding agency. 

If your organization receives federal funding, it is important to be familiar with the cost principles that apply to your organization. Most standard 501(c)3 organizations receiving federal funding will be subject to the cost principles detailed in OMB Circular No. A-122. These rules govern what is allowable under federal programs and give guidance and examples regarding cost allocation plans.

Even in instances where cost allocations are more heavily regulated, organizations still benefit from tracking their own cost allocations to ensure programs are adequately funded and should still evaluate their costs to maximize use of grant funding while remaining compliant with terms of their awards.

Whether your organization is developing an allocation methodology for the first time or is in the process of evaluating an existing methodology, including a trusted advisor such as an accountant specializing in nonprofit accounting can give you peace of mind knowing that you are properly evaluating your organization’s finances, strategically using as much of your existing funding as possible and remaining compliant with all award terms.

Questions?

If you have questions about cost allocations and would like more guidance, reach out to our Nonprofit team.

About the Author | Emily Lalas

Emily is a senior in the Audit & Assurance Services practice of Saltmarsh, Cleaveland & Gund. Her primary areas of expertise include providing audit and assurance services to the firm’s non-profit and healthcare clients. Emily is active in serving non-profit organizations throughout Pensacola and before joining Saltmarsh, she worked in bookkeeping and office administration for a regional law firm.


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