If you have ever wanted to expand your knowledge of nonprofit accounting basics, learning about functional expenses is a great place to start. Nonprofits have unique reporting requirements that set them apart from for-profit businesses. One of these reporting requirements is presenting an analysis of natural expenses by function – most commonly through the Statement of Functional Expenses (SOFE.) The SOFE is a highly effective and efficient method of reporting this required, yet also valuable, information. Beyond compliance, there are other reasons why organizations should care about tracking functional expenses.
But First, What Are Natural Expenses?
Natural expenses classify expenses based on the economic benefit the nonprofit gained in creating that expense. Put simply, natural expenses are what the organization spent its money on. Examples of natural expenses a nonprofit might incur include, but are not limited to:
- Rent and Utilities
- IT Desktop Support
- Office Supplies
- Food & Beverage
How Are Functional Expenses Different from Natural Expenses?
As previously mentioned, nonprofits are required to group expenses according to a specific purpose. Functional expenses illustrate a bigger picture and help illustrate why each natural expense was incurred. Nonprofits use the following categories – which also correspond to Form 990 reporting requirements – when recording functional expenses:
- Program Services
- Management and General
Breaking It Down: Program Services, Management and General, and Fundraising
Program costs refer to any direct expenses related to delivering the nonprofit’s programs and services to achieve its larger mission. All costs directly related to delivering programs should be recorded in this category. Ideally, this category would be the most robust on the Statement of Functional Expenses, as donors and investors prefer that nonprofits direct most of their funds towards achieving their stated mission. Nonprofits should strive to allocate most of their expenses to programs costs, provided these expenses are allocated properly and are aligned with the nonprofit’s mission.
Management and General
Management and general costs may also be referred to as overhead, administrative, or operational costs. These costs relate to the management and governance of the nonprofit. Although management and general costs do not directly contribute to the delivery of an organization’s mission, these expenses are vital to the nonprofit’s operations and sustainability.
Most nonprofits need to raise money to survive. Fundraising costs may include staff, campaigns, special events, and digital resources. In some situations, fundraising costs should be categorized under Programs rather than Fundraising.
Pulling It All Together
Salaries, employment taxes, and benefits are often the largest expense for a nonprofit and must also be allocated to the Programs, Management and General, and Fundraising categories. Ideally, employees would complete weekly timesheets to record the time spent on each category. When timesheets are not practical, another reasonably accurate method of estimating how staff time is spent should be used. Allocating payroll and other natural expenses across the functional expense categories provides nonprofit managers with meaningful full-cost data for their programs and informs current and potential funders about the efficiency of an organization in directing funds to mission-related activities.
Where Are Functional Expenses Reported?
The Statement of Functional Expenses (SOFE) is included as part of the audited financial statements. Additionally, the data from the SOFE is used to complete the Form 990. The SOFE can also be an effective management tool that provides considerable insight into how an organization’s resources – especially staff resources – are distributed to key functions. The results of a carefully prepared SOFE are often enlightening and can drive decision-making. Nonprofits may also choose to regularly report functional expenses as part of the Statement of Activities or within notes to the financial statements.
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