Cost allocation can be a cumbersome task for nonprofits, especially organizations with many activities. However, the process is critical for multiple reasons, and it’s worth reviewing your cost allocation practices regularly to ensure they’re working as intended.

Why make allocations?

Cost allocation often refers to how an organization’s costs are assigned to its programmatic, administrative and fundraising activities to determine the actual costs of those activities. While it’s obvious how some costs (usually direct costs) should be allocated, indirect costs (for example, management compensation, utilities, rent and other overhead) can prove more challenging.

Proper cost allocation is important to nonprofit management. It’s a prerequisite for accurate financial statements, which enable informed decision making on a variety of matters, including budgeting, cost cutting and program evaluation.

Cost allocation also is indispensable when it comes to grant compliance. Grants often come with budgetary and expense restrictions. Proper allocation helps you ensure adherence with grant terms and conditions. It also can reduce the risk of charging the same expense to multiple grants. And, regardless of whether you deal with grant funds, cost allocation is vital for sustainable operations. Without a reliable account of your costs, you could unexpectedly fall short of the funding needed to maintain operations, forcing you to dip into reserves or other unrestricted assets.

Allocation methods 

There are different methods to use to allocate expenses. For example, costs can be allocated to an activity based on the:

• Proportion of total employee hours that have been spent on it,
• Proportion of facility space dedicated to it, or
• Usage percentage of expenses such as supplies or equipment for it.

The selected method or methods need to be reasonable. If federal funds are involved, the methodology must comply with the cost principles in the Office of Management and Budget (OMB) Uniform Guidance. Your allocations may differ depending on the reasons for allocating.

Other tips

It’s generally wise to limit the number of different methods you use to avoid confusion and make it easier to apply the methods consistently. Developing a formal written policy that supports the methodology choices and explains how and when to apply them will also aid in consistency.

Rather than allocating each cost individually, you can simplify the process by grouping costs for similar functions into cost pools. For example, pool all indirect costs related to marketing. You can then allocate the pool to different activities. Note that the allocated percentage can differ depending on the cost category. A program might, for instance, be allocated a larger percentage of rent than of fundraising expenses, based on the method of allocation.

Make sure you maintain documentation to support your computations. When allocating salaries, you might need timesheets or other time-tracking data. For square footage allocation, you’ll need up-to-date measurements for the different departments.

Finally, review your cost allocation policy at least annually and whenever your organization has any substantial changes in programming or other activities. If you determine you should change methodologies for your new circumstances, document how and why you selected a different method.

Ask for help

Whether you’re reviewing an existing cost allocation policy or choosing methodologies for the first time, a CPA with nonprofit experience can help. Your auditors can review to avoid audit adjustments later on.