Are your performance ratios correct?

Allocating and recording direct and indirect expenses

With the advancement of watchdog agencies like Charity Navigator and GuideStar, more donors, foundations, financial institutions, and other funders are evaluating and judging not-for-profit organizations’ key ratios, including the ratio of program expenses to total expenses. The higher the percentage of program expense to total expense, the “better performing” the organization is deemed to be. Popular opinion is often that a program expense to total expense ratio below 70 percent is “poor performing.” Many have read marketing literature for organizations proudly touting a claim that “85 cents of every contributed dollar goes directly to feed the hungry, or help the poor.” This type of evaluation makes the accurate classification of expenses as either program or supporting (management and general or fundraising) critical for not-for-profit organizations.

Because of this scrutiny, organizations should carefully review how they are allocating and recording and both their direct and indirect expenses. Direct expenses are straightforward and are allocated specifically to a program or a service. Indirect expenses are costs that need to be allocated among many programs and indirect services. Often organizations dedicate time and resources to a robust review and allocation of their functional expense methodologies but then that method remains in place for years, regardless of changes in the organization. It is important that the allocation remain current and be updated annually as costs, programs and cost drivers change. Lack of an updated method can cause program expense to be understated and have the important program expense ratio also be understated –negatively affecting the organization’s reputation and image unnecessarily.

There are many important items to consider when allocating expenses across functional categories. Occupancy costs are typically allocated by square footage. It’s important as programs change to be sure these calculations are updated accordingly. Depreciation is often allocated based on how the corresponding fixed assets are used in the organization’s programs. Again, it is important as fixed assets are added and disposed of to ensure this list is properly maintained. Time allocation for employees is a critical component of successful expense allocation. As is often the case, employees may spend their time much differently than a job description or a plan might originally dictate. Tracking “actual” time spent helps the organization better allocate costs to program for salaries and related fringe benefits than trying to do this calculation broadly at the end of the year. These time allocation methods don’t need to be robust and overly time consuming (think 15 minute intervals), but a strong allocation of how each day was spent in hour blocks is an excellent tool towards more precise expense management. Other expenses need thoughtful consideration as well. For example, debt associated with a building purchased for a particular program should have the interest expense charged to that program (a true program expense). Debt for a new administrative and program building would have its interest allocated across program, management, and general and fundraising. Each situation is unique and warrants careful and proactive consideration. Because of the importance and scrutiny on these ratios and metrics, organizations need to be sure to plan and put emphasis on this calculation.

Not-for-profit organizations should be sure they develop appropriate allocation methodologies and create a plan for periodic review of these methodologies to ensure appropriateness and accuracy. An organization’s auditors can play an important role in this plan. Organizations should connect with their audit team as they challenge their current method; auditors are able to share industry best practice and offer suggestions and alternatives for more effective and efficient ways of allocation. During the year as new expenses arise and changes occur, the audit team can be a great resource to discuss the proper allocation methodology. Watchdog agency and public opinion is certainly important—coupled with proper expense allocation under Generally Accepted Accounting Principles. A great working relationship between a not-for-profit organization and its audit team helps ensure accuracy in both.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.