Functional Expense: What it is, why it matters, and how to track it

Nonprofit Organizations have increased scrutiny on their finances because of their tax exempt status. Funders want to know how much of their donation goes directly to delivering programs. The way this is recorded and reported on is through Functional Expense.

Unfortunately, many nonprofits don’t know how to track this well and/or they misunderstand the definitions of the functions. This results in a distorted view of how much the organization spends on programs and can mislead potential donors and rating agencies.

What is Functional Expense

Functional expense refers to what an expense is for, as opposed to what an expense is. Here’s an example:

An expense at Fedex for printing program flyers

What is the expense? It is a Printing Expense

What is it for? It’s for Program Services

The accounting jargon for this is natural classification (what the expense is) versus functional classification (what the expense is for). The natural classification refers to the normal expense accounts such as printing, supplies, travel, etc. In this case it is a printing expense. The functional classification refers to the three functions that a nonprofit must track: Program Services, Management & General, and Fundraising. In this case it is a program services expense. These are defined in detail below.

Why Functional Expense Matters

This is public information. It is required for the 990 and utilized by rating agencies such as Guidestar and Charity Navigator. Donors can see what percentage of expenses go towards programs and may have a judgment about it when considering giving.

A general consensus persists among funders and rating agencies that a nonprofit should be spending around 80% on program services.

It’s important to note that there is an increasingly popular opinion among funders and nonprofit professionals to the contrary. Some say that this expectation prevents nonprofits from investing in staff, infrastructure, and sustainable operations. This results in overworked staff and insufficient operations support.

Regardless of the progress of the paradigm shift, the functional expense allocation is still required on the 990, is part of Generally Accepted Accounting Principles (GAAP), and is used by rating agencies.

How to Classify Functional Expense

According to GAAP for nonprofits, an organization must have a clear allocation methodology for functional expenses. With a good bookkeeper, a clear system can be implemented to track the function for each expense. The way this is done may vary by accounting platform. With QuickBooks, this is usually done using “Classes”. No matter the system, a consistent methodology should be used.

Direct Expenses

A direct expense is an expense that clearly falls into a single function. An example of this is a program supply for a specific program. The total amount of the expense is categorized into the program function.

Indirect Expenses

An indirect expense is an expense whose function varies. A prime example of this is personnel expense. The executive director likely spends time working for all of the functions. They spend time working with the board (Management & General), raising money from major donors (Fundraising), and working on programs (Program Services). Therefore their salary and other costs will need to be split across functions. This is known as indirect expense allocation.

It’s important to have a clear expense allocation methodology. Your bookkeeper or accountant can help you to identify these splits and create a clear procedure. We won’t dive into detail on that in this article.

Defining the Functions

The IRS publication “Instructions for Form 990 Return of Organization

Exempt From Income Tax” spells out how to categorize these functions correctly.  Nonprofits can use these definitions to inform how to categorize and allocate expenses. The good news is that if done correctly, most organizations can achieve the 80% program service expense goal. 

What is Management & General?

Let’s start by looking at Management & General (M&G) since this is the most misunderstood function. Note that the title of this function does not use the word “Administration” or “Overhead”.  

Administrative work can be for programs or fundraising or M&G. Many nonprofits mistakenly put all administrative staff expenses into the M&G function even if the staff member spends their time administering programs. This is incorrect and leads to inflated M&G expense percentages.  

“Overhead” is a term used on grant applications and does not correlate to functional expense categories. Oftentimes, expenses that a funder may not allow as a direct budget line in a grant, may still be programmatic in nature and not necessarily belong in the M&G function, even though it is lumped into an “overhead” budget line item.

The IRS defines Management and General expenses as “...expenses that relate to the organization's overall operations and management”. By default anything related to the Board of Directors or Accounting falls into the M&G function. This includes D&O insurance, tax prep, bookkeeping fees, tax registrations, etc.  

This does not necessarily include 100% of admin staff or the executive director's cost. Nor does it necessarily include 100% of office supplies, rent, or online subscription services. It is likely that those expenses should use an indirect allocation and be split depending on the function they serve.  

Staff time spent on the overall management of the organization does belong in M&G. This will usually include a portion of the Executive Director’s time and other Operations staff. This includes time spent on “overall management and operations”.  Specific examples of this are time spent working with the board, budgeting or other finance activities, strategic planning, organization wide management and HR duties. When allocating staff time it’s important to think through how the employee uses their time and allocate accordingly.

This is not cheating. The IRS instructions specifically advise using indirect allocations for these expenses.  

What is Fundraising?

Fundraising is much more straightforward, but there can still be misunderstandings when it comes to staff allocations.

The IRS says, “Fundraising expenses are the expenses incurred in soliciting

cash and noncash contributions, gifts, and grants”.

This means that any expense directly related to fundraising belongs here, such as your donor database, direct mailing expense, time spent soliciting donations, etc. 

It’s important to be clear when allocating staff expenses to fundraising. Staff time spent directly soliciting funds, developing grant applications, and communicating with donors belongs here. Time spent advertising your services and enacting the educational component of your mission is not necessarily fundraising.  

What is Program Services?

Most of a nonprofit’s expense falls into this function. The IRS explains that program services  “...are mainly those activities that further the organization's exempt purposes”. This is a broad definition.  

Nonprofits typically spend most of their time and money on directly furthering their mission. This includes any expense for your programs including direct supplies as well as the time of any staff member in support of the programs.  

It’s important to include the time of any staff member’s work spent supporting programs. For example, an administrative support staff may spend a good portion of their time coordinating program logistics and managing the beneficiaries of the programs. Additionally, the executive director may spend time managing the programs at a higher level and working on program development. 

Conclusion

Functional expense allocation is necessary, but with a clear procedure it's easy. By following the IRS guidance and developing clear indirect expense allocation procedures, it's easy for an organization to show a majority percentage of expense as program services expense. This helps to ensure donors of the efficacy of their donation and leads to higher ratings from the rating agencies.  

Yes, there is a paradigm shift underway to rid the nonprofit world of the 80% program expense expectation. Until then, nonprofits must follow GAAP and allocate their expenses by function accordingly.