The What and Why of Functional Expenses
Functional Expenses Defined
Functional expenses are synonymous with a number of accounting terms: class, buckets, cost centers, project codes, etc. Nonprofit organizations rely on functional expenses to identify and allocate organizational departments and programs. This process allows your nonprofit to distinguish the purpose of expenses and revenues in a complex way that accounts just don’t feature.
For most nonprofits, all activity falls under these three main tiers. Industry benchmarks estimate 5-10% of all activity is directed toward fundraising, 10-15% toward administration and the remaining activity toward programs.
Applying Functional Expenses
Analysis is the key to delineating functional expenses correctly. For example, wages earned can have many definitions. Salary is a great example. How you devote your time to the various activities of your nonprofit is described by your functional expenses, and should be broken down by area (fundraising, programs, administration etc.) In contrast, an account will only denote the total salaries earned. This difference between accounts and functional expenses is consistently true.
If you are applying all Executive Director and Project Manager’s earnings to the administrative function, then in all likelihood, you are not portraying an accurate picture of how you and your employees spend their time and effort. Instead, describe how your staff devotes this time and effort to the organization in terms of functional expense. Do they spend 15 hours a month on things related to fundraising? 25 hours on aspects of administration? Characterizing salary this way will give your organizational operations and financial statements a stronger narrative. This representation of your finances allows you to appeal to current and future donors.
Keep in mind
- All items on the profit and loss statement should be allocated to your functional expenses. This refers to all revenue and expenses recognized in the current accounting period.
- It is considered best practice to provide your bookkeeper with functional expenses and account allocations for all transactions.
- Functional expense lists should also be updated a once every fiscal year, at minimum. New programs, fundraising events, and organization locations are often integrated into your lists at this time.