Allocations Part II

Last week, I began the unenviable task of explaining expense allocation reporting in non-profit organizations.  I mentioned that there are four common entries and I described DIRECT ALLOCATIONS and SALARY ALLOCATIONS.  Today, I would like to wrap up this topic by writing a bit about the other two types of allocation entries.  If you have a chance to look at Part I, it is helpful to understanding this discussion.

GENERAL EXPENSE ALLOCATIONS

General expense allocations refer to expenses that are not easily identifiable to a program.  Examples include copier leases, office supplies and insurance costs.

Note that worker's compensation insurance would fall in this area even though it is an employee expense - it is not an expense that can normally be broken out by individual and so it would not be considered under the salary allocation entry.

These expenses are typically accumulated on a monthly basis and recorded as either an unclassified or an administrative cost.  As part of closing out the month's reporting, these costs would then be allocated out to the various programs.

The preferred method used for allocating these costs is generally effort reporting.  Effort reporting takes into account the amount of time that employees spend on a program and applies that effort to the general expenses.

The theory behind this method contemplates that an employee is spending 50% of their time doing the After-School work and so they must be using 50% of the copier costs on After-School work.  This method, applied consistently, will survive an audit of cost allocation.

Effort reporting is NOT the same as salary allocations, but you do start in the same place - with the timesheets.  If you remember, we used the hours on the timesheets to generate the percentages for each individual's payroll costs.  The total percentage used for payroll can NOT be used for general expense allocation because it is skewed based on different salary levels.  The total hours in a program can be used.  Here is an example to explain what I am talking about:

S is the Executive Director and makes $4,000 per month.  She spends 80 hours (50%) in Programs and 80 hours (50%) in Fundraising.
T is the Program Manager and makes $2,000 per month.  She spends 128 hours (80%) in Programs and 32 hours in Fundraising (20%).

For Salary Allocations, you would do this:
Payroll Expenses would be allocated 60% to Programs and 40% to Fundraising.

The program expense is S's salary of $2,000 (50%) plus T's salary of $1,600 (80%) to equal $3,600 (or 60% of $6,000 in Payroll Expense).

This fundraising expense is S's salary of $2,000 (50%) plus T's salary of $400 (20%) to
equal $2,400 (or 40% of $6,000 in Payroll Expense).

The Salary Allocation is 60/40 because the Executive Director makes more than the Program Manager and skews the salaries.  You have no choice but to take actual payroll costs on the Salary Allocations, but you do not want to apply this skewing to other costs.  The copier does not cost more to use when the Executive Director is doing it.

For General Expense Allocations, you would do this:
General Expenses would be allocated 65% to Programs and 35% to Fundraising.
This is comprised of the total of S and T's Hours = 320.  Of those hours, the total Program Hours are 208 and the total Fundraising Hours are 112.

While a 5% difference does not seem like much - keep in mind this is a very limited example.  When you pull it out to the population, the difference can be larger.

Volunteers
I have used Volunteer hours when calculating general expense allocations, if it makes sense.  If your volunteers are on-site doing program related work that use up general expenses, then why not include them in the effort reporting?  You can't put them in salaries, but you do want to be reasonable about just how much that copier is getting used for your program.

Let's look at the above example and add in the hours for the Volunteer that runs the After-School program.  If their hours are 20 per month, you now have 340 total hours - 228 to Programs and 112 to Fundraising.  Or a general expense allocation split of 67% Program and 33% Fundraising.

Volunteer time makes sense for some organizations, but not all.  If you decide to use it, you should be prepared to explain why it makes sense and to demonstrate that you used a complete tally of volunteer time (not just the program hours).  Again, timesheets are useful for providing the substantive back-up.

OCCUPANCY ALLOCATIONS

The fourth most common allocation entry is occupancy.  Occupancy costs include rent, interest on a mortgage, utilities, depreciation and sometimes maintenance expenses.

The preferred method for allocating occupancy costs is based on the square footage that a function literally takes up within the office.  If a program is off-site completely, then the allocation might be the costs of the off site location or it might have to come from an application of the general expenses allocation method to occupancy.

Getting a layout of your office is the first step to figuring out how you want to allocate.  Sit down with that layout and calculate the square footage of each area to each function.  Apply that percentage to the occupancy costs on a consistent basis and you're done.

This allocation should be re-visited at a minimum on an annual basis, but may require a more periodic review.  Especially if there is a major shift in office layout or new programming is added.

BONUS ALLOCATION DISCUSSION - ADMINISTRATIVE COST ALLOCATION

After all other allocations are completed, you may want to perform an allocation of administrative costs to the various programs.  Note that this would be for funders that allow it and for internal management reporting purposes.  A full allocation method like this would present a program's contribution to the overhead of the non-profit.  On tax returns for non-profits, general and administrative expenses must remain separate.

This is very easy to do - again, after everything else is allocated, just take your general and administrative expense total and apply it using the formulas that you used to do the general expense allocations.  With one tweak.

If your General Expense Allocation was 10% Administrative, 10% Fundraising and 80% Programs; then you would want to allocate all Administrative between Fundraising and Programs.  Your allocation would be based on Fundraising being 10 of 90 or 11%.  The allocation to Programs would be 88% or 80 of 90.

General Expense allocation is normally shown as a separate income statement line item - it is a lump adjustment at the bottom of reporting and it should add up to zero for top-level and tax reporting.

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I know all of this is a lot to think through objectively while staring at a computer screen, but it is the way we do it.  And once you get these allocations set up and start running through them a few times, it becomes very systematic and can easily be done by a solid general ledger accountant.

Knowing that your allocations are correct and supportable will give you credibility within your organization and within the various funding communities that you operate.  It will also give you a lot of information for when you are building budgets.  Allocations are worth understanding, setting up properly and vigorously maintaining.

Allocations Part I

In my post last week on Charts of Accounts, I mentioned that since I started serving non-profit organizations almost exclusively, I have struggled with the allocation of costs.  I noted that there are allocations required for grant reports, for tax returns, for financing compliance, for management reporting and sometimes just because a Board member wants to know a random bit of information.

Allocating costs is a function of taking the expenses of an organization and assigning them to a program or cost center.

In non-profits, the three areas that MUST be tracked and reported for the annual tax return are administrative, fundraising and program expenses.  All non-profit tax returns are considered public information and can be downloaded with ease from the Internet through a provider such as Guidestar (which is free to join).

In addition to these three areas, an organization may want to track the expenses of several individual programs to roll into that "program expenses" on the tax return.

It is the disclosure of expenses that provides the non-profit, and other interested parties, information on how much money is spent performing its exempt function.  You will commonly hear this phrased as "Eighty-two cents of every dollar goes to help..."

It is worth noting that the bigger an organization gets, the smaller their administrative costs should be.  I work with primarily small organizations who don't benefit from large organizational efficiencies.  As such, it is expected that administrative and fundraising costs together will equal between 23 and 28% of total costs.

That percentage will vary depending on the type of services the organization performs, but I would venture to say that if you see a small organization that gets these costs below 10%, they probably aren't doing their allocations properly.

I thought today I would begin going through the four most common allocation entries that we see.

DIRECT ALLOCATIONS

Direct allocations are the easiest to track.  This is when an expense is readily identifiable to a program.  If you buy supplies for an after-school camp that you put on, those supplies would be coded and entered directly to that program.

If I was using QuickBooks for a client in this case, I would have an account called Program Supplies and I would use a class code called After-School.  The invoice would be entered directly to the program and you are done.

The more direct allocations you can do, the cleaner and easier it is to track expenses by function.

SALARY ALLOCATIONS

The largest expense in most social service organizations is generally salaries.  Salaries and related costs need to be allocated based on actual time spent on a task.  This means we have to have timesheets.  There is no getting around it.  Unless you have a person who is 100% in one program and one program only, a luxury most small organizations do not have, then you will need to have an understanding of exactly where each person is working.

If you receive funding from government sources, or if you just want to do salary allocations properly, then you have no choice but to get this information.

Related costs of salary include payroll taxes, employee benefits, 403B matches and vacation or PTO accruals. All of these costs can be specifically identified to an employee and should be allocated based on that person's work.

I take timesheets periodically from the staff at my clients and I enter them into an excel spreadsheet, summarizing each person by program.  I then convert the hours to a percentage for application of the salary costs.  I apply that percentage to the employee's costs and record the allocation.

In this case, you would probably enter payroll either to administrative costs or unclassified costs and then go through and clear out the payroll entry through the allocation entry.  That way you can match the payroll payment to the payroll reports (good for audits) without having to add up all the allocations.

An example would be:

1. Pay Jane
Debit Payroll Expense    2,000.00  Unclassified
Debit Payroll Taxes           200.00  Unclassified
          Credit Cash or Salary Payable   2,000.00  Unclassified
          Credit Cash or Taxes Payable       200.00  Unclassified


2. Allocate Jane - 50% to After-School, 25% to Before-School, 25% to Administrative
Debit Payroll Expense   1,000.00  After-School
Debit Payroll Expense      500.00  Before-School
Debit Payroll Expense      500.00   Administrative
          Credit Payroll Expense    2,000.00  Unclassified

Debit Payroll Taxes          100.00   After-School
Debit Payroll Taxes            50.00   Before-School
Debit Payroll Taxes            50.00   Administrative
          Credit Payroll Taxes           200.00   Unclassified

If you draw a T-Account you will find that you still have $2,000 in Payroll Expense, but now it is in three different buckets.  The back-up for the second journal entry would be Jane's timesheet matched to the allocation workpaper.  You may also have to provide payroll records to a government auditor.

Allocating salaries is expected to take the most amount of time and effort in non-profit accounting.  It is also the most important activity; because, as the biggest cost, it is going to have the most direct impact on that percentage that I spoke about above - the amount of costs that go to providing services.

If you are hoping to be or are funded through large foundations or government sources, this allocation should always be prepared carefully, so that you can maintain credibility in the funding community.

A note about volunteers and salary costs:  Unfortunately, you can not allocate volunteer time in Salary and related cost expense.  Volunteers are often helping provide services and are rarely performing administrative functions.  This is one of the reasons that smaller organizations have higher administrative costs - they may only have two staff that do 100% of the administrative work, but they have a large volunteer pool helping with the programs.  The volunteers are not recognized in these expenses.

While that does not seem fair, it is a situation that most people face, and it is understood by grantors and other knowledgeable financial statement readers.  It is also something to keep in mind when you are writing your narrative to go along with your financial presentation.  A note describing your wonderful volunteer support (and the savings you obtain from not having to hire employees) is always a good idea.

In Part II, I will give an example of when volunteer time may be used to impact the cost allocations as we discuss the other two common allocation entries:  GENERAL EXPENSE ALLOCATIONS and OCCUPANCY ALLOCATIONS.

Charting Your Accounts - NonProfit Version

It seems like a good time to talk about the chart of accounts.

Oh, I know it's not sexy.  And it's not really that fun.  Personally, I  try to have a career goal of never changing a chart of accounts again.  Yet, if you plan your chart of accounts properly, it really can be used for a long time to come.

I have to admit, since I started serving non-profit organizations almost exclusively, I have struggled with the allocation of costs.  There are allocations that are required for grant reports, for tax returns, for financing compliance, for management reporting and sometimes just because a Board member wants to know a random bit of information.

I have spent hours on the phone with colleagues trying to determine if I was really doing these allocations right, when I am making entries that have $0.20 in them.  I am.  Unfortunately.

I have learned, however, the more allocations you can do through initial transaction entry, the better off you are.  And a flexible chart of accounts consistently used aids that process.

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Lets take a look at the basics of a chart of accounts.  Note that this is a discussion of the actual account numbering; it is not about categorizing the chart into revenues or expenses or what have you.  I consider the categorizing a function of reporting and it is beyond the scope of this post.

NATURAL - Your first numbers should match the natural expense categories.  This is expected and necessary if you have to file a tax return or undertake a financial audit.  A natural expense would be Salary.  Or insurance.  Utilities, etc.  It is common for people to use four or five numbers for this category.  Example:  Repairs - 6120.

SUB-NATURAL - This category is not used often, but I have worked with it before and I really love it.  This is when you take a natural expense and give it a sub-category.  Two numbers is generally sufficient for this category.  Example:  Carrying on with Repairs, you might have Repairs on the HVAC System - 6120.02.  Note that you could now do reporting on all repairs or just on repairs related to HVAC.

PROGRAM - This is where you start breaking out different departments or functional areas of expense.  In non-profits, this could be administrative, fundraising and various programs.  Having this segment allows you to report by functional expense and accumulate your administrative or overhead costs for allocation purposes.  Most small and medium size businesses are okay with two numbers here.

Example:  Repairs on the HVAC system at the administrative office would look like this - 6120.02.99.  Repairs on the HVAC system related to a program could be - 6120.02.05.

A note about QuickBooks: 
QuickBooks is a common accounting software that has a some very frustrating limitations to its chart of accounts structure. You can't add dashes or dots in the basic versions and the most numbers you can use is seven. Seven.

With only seven numbers and no breaks, it is hard to properly separate programs (departments) and funders.  In QuickBooks, I generally use classes to track programs, since I am already up to 5 or 6 of the allowable account numbers. However, classes add a complicated element to data entry, as they must also be used consistently to work properly.  If you have too many, you risk errors and "messes."

ACTIVITY - Activity and program could be the same, but it might be used as a sub-program.  For example if you are a theater arts business, your program could be Plays and an activity would be The Taming of the Shrew.  It makes sense in this case to track activities, but unless you are going to recycle charts of accounts (which is not recommended), you will need a lot more number spaces here - three at a minimum, but more likely four.  Example:  Repairs on the HVAC system at our play, the Taming of the Shrew (keep an open mind here as I try to keep my examples consistent) - 6120.02.05.1420.

You will notice that we have gone way beyond QuickBooks limitations at this point.

LOCATION - Location may be more important to your business than activity or it may be an additional area of interest.  Location notifiers are probably sufficient with two digits.  Example:  Repairs on the HVAC system at our play, the Taming of the Shrew, which is held at the downtown community theater - 6120.02.05.1420.06

SOURCE - And finally, we reach the really important area.  Source is when you might want to track funding sources for a program or activity.  This is vital for grant reporting, but is similar to activities in that you may need a large number of digits - I would say at least three.  Example:  Repairs on the HVAC system at our play, the Taming of the Shrew, which is being shown at the downtown community theater and which was funded by the National Endowment for the Arts - 6120.02.05.1420.06.150.

I use customers in QuickBooks a lot to track this information, but it does cause problems as it is very hard to keep it consistent.  Others find job tracking to be helpful here, but again, there are limitations.

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Let's see what we have ended up with, assuming we want everything:  6120.02.05.1420.06.150

Okay, I admit that this account number has gotten a bit ridiculous, but if you look at it, you could run reports on several different aspects just from a download to Excel.

All of these segments are sortable!  It's the Holy Grail of accounting reporting!  You can report on any of the following:

Repairs
HVAC Repairs
Plays
The Taming of the Shrew
Any plays held at the Downtown Community Theater
Expenses funded by The National Endowment for the Arts

It is amazing!  But...

Let's get back to reality.

You likely do not need all of these segments, but you do need some of them.  Regardless of how many you do use, any account separation will give you flexibility as your organization changes and grows.

I beg you - don't just randomly accept the canned chart of accounts that comes with the accounting software.  Take some time, approach it thoughtfully.  Look at your current reporting needs and structure your accounts accordingly.

It will be worth it in the end.