Nonprofit Insights & Giving Tips

Nonprofit expenses rarely fit neatly into one simple category. An organisation may employ a program director who spends most of the week delivering services but also supervises staff and attends fundraising meetings. Office rent supports employees performing several different functions. Technology, insurance, accounting, communications and leadership costs may support the organisation as a whole rather than one individual program. This makes functional expense allocation an important part of nonprofit accounting and financial reporting.

For many U.S. nonprofits, expenses are commonly viewed across program services, management and general activities, and fundraising. Form 990 uses these functional categories in its Statement of Functional Expenses, and accounting standards also require certain nonprofits to provide information about expenses by both natural and functional classification. The challenge is not simply producing percentages at year-end. Organisations need a reasonable and consistently applied method for deciding where shared costs belong. They also need to explain why a single nonprofit overhead ratio does not provide a complete picture of organisational effectiveness.

Understand the Difference Between Natural and Functional Expenses

Natural expense classifications describe what the organisation purchased or paid for. Salaries, rent, insurance, professional fees, travel, supplies and technology are examples of natural categories. Functional classifications answer a different question. They identify the purpose served by the expenditure, such as program services, management and general activities, or fundraising.

The distinction matters because one natural expense can support several functions. Payroll might include employees working entirely on programs, employees performing administrative work and fundraisers whose work supports contributions. Rent may support all three activities because staff from several departments occupy the same office. Functional reporting therefore requires organisations to look beyond the accounting account where a transaction was originally recorded and determine how the cost supported the organisation’s activities.

What Counts as Program Services?

Program service expenses generally relate to activities that directly further the nonprofit’s exempt or mission-related purposes. A food assistance organisation may classify expenses related to purchasing and distributing food as program costs. An educational nonprofit may classify instructor compensation and classroom materials as program expenses. A community organisation may have several separate programs, each with its own staff and direct operating costs.

The IRS Form 990 instructions describe program services as activities that form the basis of an organisation’s exemption from tax. This does not mean every employee who believes their work supports the mission should automatically be classified entirely as program staff. Most nonprofit activities ultimately exist to support the mission in some way. Functional reporting requires a more specific analysis of what activity was actually performed and which function benefited from the related expense.

What Counts as Management and General?

Management and general expenses usually relate to the overall management and administration of the organisation rather than to a particular program or fundraising activity. These can include certain accounting functions, governance activities, general management, legal services, financial administration and other organisation-wide support functions.

The category is sometimes casually described as “admin,” which can create confusion because administrative employees may perform work that belongs in different functional categories. An employee processing registrations for a specific program may be performing program-related work even though the task feels administrative. By contrast, someone preparing organisation-wide financial statements may be performing management and general work. Classification should follow the function of the activity rather than an employee’s job title alone.

What Counts as Fundraising?

Fundraising expenses relate to activities undertaken to generate contributions and financial support. They may include fundraising staff compensation, donor campaigns, fundraising events, direct mail, fundraising technology and certain costs associated with cultivating supporters.

Form 990 separately reports fundraising expenses in Part IX, alongside program services and management and general expenses. Organisations should therefore have a process for identifying fundraising activity even when employees perform several different duties. A communications employee, for example, might spend part of the year promoting programs and another portion creating donor appeals. The proper allocation depends on the actual work being performed and the applicable accounting guidance rather than assigning the entire salary to one category for convenience.

Why Functional Expense Allocation Matters

Functional allocation affects financial statements, Form 990 reporting, grant budgets, internal management reports and the way donors interpret an organisation’s spending. An allocation methodology that pushes almost every shared expense into programs may create an attractive program percentage, but it can also provide an inaccurate picture of operations.

Reliable reporting is more useful than artificially impressive ratios. Boards need to know what it actually costs to manage the organisation. Funders may need to understand the infrastructure required to deliver a program. Management also needs accurate information to budget for technology, finance, human resources and other supporting functions. Functional expense reporting should therefore help explain the organisation rather than simply produce a desired percentage.

Direct Expenses Should Usually Be Identified First

The simplest expenses to classify are those that clearly belong to one function. If a consultant is hired specifically to evaluate one program, the related fee can generally be associated with that program. Materials purchased solely for a fundraising event can usually be identified as fundraising costs. A conference attended only by the finance team for organisation-wide accounting responsibilities may relate to management and general activities.

Identifying these direct costs before allocating shared expenses simplifies the process. The organisation does not need to create complicated allocation formulas for costs that can already be traced to one purpose. Attention can instead focus on genuinely shared expenses such as executive compensation, rent, utilities and technology. Good accounting systems can make this easier by assigning departments, programs or functional codes when transactions are first entered.

Shared Salaries Require a Reasonable Allocation

Compensation is often one of the largest expenses for a nonprofit, which makes salary allocation especially important. Some employees work entirely within one function, but many divide their time across several responsibilities. A chief executive might manage the organisation, participate in fundraising and occasionally contribute directly to program strategy. A program manager may deliver services while also carrying out general supervisory responsibilities.

The IRS Form 990 instructions specifically recognise allocation of employee compensation across functions. They give an example in which an employee who spends 40 percent of their time on fundraising and 60 percent on program management has their salary allocated accordingly. Organisations should establish a reasonable process for estimating or documenting these allocations and apply it consistently rather than selecting percentages solely to achieve a preferred result.

Time Studies Can Improve Salary Allocations

When employees regularly divide their time among functions, periodic time studies can provide evidence for allocation percentages. This does not necessarily mean every nonprofit employee must track every minute of every day indefinitely. The appropriate level of documentation depends on the organisation, its funding arrangements and applicable requirements.

A time study might examine representative periods during the year to understand how an employee’s responsibilities are divided. If the pattern changes significantly, the allocation should be reviewed. For example, an executive director may devote significantly more time to fundraising during a capital campaign than during an ordinary year. Using a fixed percentage forever simply because it was established several years ago can gradually make reporting less accurate.

Job Titles Should Not Determine the Allocation

It is tempting to assume that a program director’s entire salary belongs to programs or that an executive director’s entire salary belongs to administration. Actual responsibilities may be more complicated. A program director could spend significant time on organisation-wide management, while an executive director might participate directly in program delivery.

Functional allocation should therefore begin with activities rather than titles. Job descriptions can help, but they should be compared with what employees actually do. This principle also prevents an organisation from changing job titles merely to influence ratios. A strong methodology should produce similar results even if internal titles change because the classification follows the underlying work.

Allocate Occupancy Costs Based on a Defensible Driver

Rent, utilities, cleaning and other occupancy expenses often support several functions simultaneously. One common approach is allocating these costs based on the amount of space used by different departments or activities. If program staff use 70 percent of office space, fundraising uses 15 percent and administration uses 15 percent, that distribution may provide a reasonable basis for certain occupancy costs.

However, square footage is not always the best driver. A facility may contain program rooms used by participants only part of the week, shared meeting rooms and administrative offices. The organisation should choose a method that reasonably reflects how the resource is used. The objective is not mathematical perfection. It is a consistent and supportable approach that reflects operations closely enough to produce useful financial information.

Technology Costs May Need More Than One Allocation Method

Software and technology have become significant nonprofit expenses. Some platforms are clearly connected with one function. A donor management platform may primarily support fundraising, while software used exclusively to deliver an educational service may be a program cost.

Other systems, such as email, cybersecurity tools, file storage and accounting software, can support the whole organisation. Allocating every technology cost using one percentage may therefore oversimplify the picture. Organisations can group similar systems and choose an appropriate driver for each category. The methodology should remain practical enough to operate consistently rather than becoming so complex that staff cannot maintain it.

Insurance Can Support Multiple Functions

General liability, directors and officers coverage, cyber insurance and other insurance expenses may protect different parts of the organisation. Some policies apply broadly across the entire entity, making direct assignment difficult.

A reasonable allocation method can be used when insurance supports several functions. The driver might relate to payroll, staff count or another relevant measure depending on the type of insurance. The important point is that the organisation should understand why it selected that method. Allocation policies are stronger when there is a logical connection between the expense and the factor used to distribute it.

Professional Fees Need Individual Review

Professional fees are frequently grouped together in accounting systems, but they may have very different functions. Audit and accounting work can relate primarily to management and general activities. A consultant hired to design a program evaluation framework may be directly related to program services. A fundraising consultant may clearly belong to fundraising.

Reviewing professional fees individually can therefore produce more accurate reporting than allocating the entire account based on a general formula. Larger or unusual invoices deserve particular attention. Coding them correctly when entered into the accounting system reduces the amount of reclassification work required at year-end.

Management and General Should Not Become a Catch-All Category

When staff are unsure how to classify an expense, there can be a tendency to place it in management and general. Over time, this can make the administrative category larger than it should be and reduce the usefulness of functional reporting.

The opposite problem also occurs when organisations try to avoid administrative costs and push ambiguous expenses into programs. Neither approach improves transparency. Instead, unclear expenses should be examined based on what activity or function benefited. An organisation-wide expense may genuinely belong in management and general, while another apparently administrative cost may directly support program delivery. The classification should follow the facts rather than a preference for a particular ratio.

Understand What People Mean by Overhead

“Overhead” is widely used in nonprofit conversations, but it is not always used with the same precision as formal accounting terminology. The National Council of Nonprofits describes overhead generally as the combination of management and general expenses and fundraising expenses, while Form 990 reports program, management and general, and fundraising separately.

This distinction becomes important when discussing the nonprofit overhead ratio with donors or board members. One person may be referring only to administrative costs while another means administration plus fundraising. Before comparing percentages, organisations should define exactly which expenses are included. A ratio cannot be interpreted properly when different organisations are calculating it from different categories.

How the Overhead Ratio Is Commonly Calculated

A common overhead calculation divides management and general plus fundraising expenses by total expenses. If a nonprofit reports $800,000 of program expenses, $120,000 of management and general expenses and $80,000 of fundraising expenses, total expenses are $1 million. Under this approach, combined overhead would be $200,000, producing an overhead ratio of 20 percent.

The calculation itself is easy. Interpreting it is much harder. Two organisations with identical ratios may operate very differently. One may have invested heavily in cybersecurity, financial controls and fundraising capacity, while another may be underinvesting in infrastructure. The ratio shows how expenses were classified, but it does not by itself reveal whether the organisation is financially healthy, well managed or producing meaningful outcomes.

There Is No Universal Ideal Overhead Percentage

Donors frequently ask what percentage of expenses “should” go to programs. There is no universal percentage that proves a nonprofit is effective. The National Council of Nonprofits states that there is no set percentage that indicates one nonprofit is operated more effectively than another and argues that essential operating costs should not automatically be treated as evidence of inefficiency.

Different missions require different cost structures. A volunteer-run organisation distributing donated supplies may have very different administrative needs from a national organisation employing specialists, operating secure technology systems and conducting complex program evaluations. Comparing the two solely through overhead percentage can ignore the resources each actually needs to deliver its mission responsibly.

Why Extremely Low Overhead Can Be a Warning Sign

A very low overhead percentage may initially sound impressive. However, an organisation that consistently avoids spending on financial systems, technology, staff development, cybersecurity, fundraising and management may eventually struggle to operate effectively.

Infrastructure has a cost. Accurate accounting requires skilled people and systems. Protecting donor and beneficiary information requires technology and security. Recruiting employees requires human resource capacity. Generating future contributions requires fundraising activity. The National Council of Nonprofits has warned against unrealistic overhead ratios and the broader “overhead myth” that treats minimal support spending as an automatic sign of quality. A sustainable organisation needs enough infrastructure to support its mission rather than simply the smallest possible administrative budget.

High Overhead Also Deserves Explanation

Rejecting the idea of one ideal ratio does not mean overhead should never be examined. If management, general and fundraising expenses rise substantially while program activity remains flat, boards and management should understand why. A temporary increase may be entirely reasonable if the organisation is implementing new technology, building fundraising capacity or strengthening financial controls.

The question should therefore shift from “Is this ratio too high?” to “What is driving the ratio, and is that spending supporting the organisation’s strategy?” A good explanation connects expenses with decisions. If administrative costs grew because the organisation hired its first finance director after expanding rapidly, stakeholders can evaluate that investment in context rather than reacting only to the percentage.

Program Percentage Can Also Be Misleading

The program expense ratio is often calculated as program services divided by total expenses. Organisations sometimes promote statements such as “90 cents of every dollar goes to programs.” While mathematically simple, this figure can create an incomplete picture of organisational performance.

A high program percentage does not indicate whether the program works. An organisation could spend 95 percent of its expenses on poorly designed services and create little meaningful impact. Another could spend a lower percentage while maintaining strong evaluation, safeguarding and financial systems that allow programs to perform consistently. Expense allocation measures inputs, while mission effectiveness requires information about outputs and outcomes as well.

Avoid Manipulating Allocations to Improve the Ratio

Pressure to report a high program percentage can unintentionally influence accounting decisions. Employees may feel encouraged to assign shared salaries or expenses to program services because the result looks better in fundraising materials.

This creates a serious governance problem. Functional allocations should follow reasonable accounting methods, not public relations goals. Management should be able to explain the rationale behind significant allocations and apply the methodology consistently from period to period. If methods change, the reason should be operational or accounting-based rather than simply a desire to improve the reported percentage.

Document the Allocation Policy

A written functional expense allocation policy helps employees, accountants, auditors and board members understand how shared costs are distributed. The policy can identify common expense categories, the allocation drivers used and how frequently assumptions are reviewed.

The document does not have to predict every unusual transaction. It should provide a framework employees can apply consistently while allowing significant exceptions to receive individual review. Documentation is especially useful when staff members change. Without it, new accounting personnel may use different assumptions, creating unexplained fluctuations in functional expenses from one year to another.

Review Allocation Drivers Regularly

Allocation methods should reflect current operations. A nonprofit that once employed ten program employees and two administrative employees may later double its fundraising department or move programs into another facility. Old percentages may no longer represent how resources are being used.

Management should therefore review significant drivers at least periodically and whenever operations change materially. Square footage, staff time, headcount or usage data can all change. Updating an allocation method is not a sign that the old one was necessarily wrong. It may simply mean the organisation has evolved and the accounting approach needs to follow.

Be Consistent From Month to Month

Waiting until year-end to allocate every shared expense can create a large accounting project and leave management without useful functional information during the year. Where practical, organisations can incorporate allocation methods into monthly accounting.

Consistent monthly allocations help management compare actual expenses with budgets and identify changes earlier. They also make year-end reporting easier because the organisation is refining an existing process rather than rebuilding the entire functional statement. Certain adjustments may still be necessary after reviewing annual time studies or updated allocation drivers, but the underlying records should already be organised.