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• Employee and Subcontractor Information
• • Employee vs. Subcontractor: What’s the Difference & Why You Should Care
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  • What’s the Massachusetts WorkShare Program?
  • What's the Real Cost of an Employee?
  • IRS - Independent Contractor or Employee
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• Nonprofit Information
• • Cost Allocation for Nonprofits
  • The New Form 990: What Does it Mean for Smaller Nonprofits?
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  • Jo Landers Bookkeeping Clients
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See also Payroll Services

How Costs are Allocated

Cost allocation can be done in a variety of ways depending on what financial software package an organization is using and what kinds of things it needs to track. In Quickbooks this is usually done using classes, often supplemented by spreadsheets. For-profits may also use classes to divide income and expenses, but generally don’t need to in order to prepare tax returns. For example, a landlord with several buildings might use classes to track income and expenses for each property or unit, or a business might use them to track various product lines, giving a clearer understanding of what is most profitable for them.

Direct and indirect costs

There is a further distinction between direct costs and indirect costs. Direct costs are clearly related to a specific category or program. Examples include printing and mailing an annual appeal for fundraising purposes, a toll-free telephone number used by a help line program, or insurance and supplies for a particular event. Indirect costs are less clear; they include things like HR and bookkeeping, or office supplies and physical plant expenses, which are necessary to the overall operation but may also be used by various programs. Indirect costs tend to be fairly stable over time, while direct costs may vary widely depending on changes from year to year in restricted or donor-advised funding and what program services are provided.

Since indirect costs are shared, they must be divided and allocated between various supporting activities and program services. There are no clear-cut guidelines for how this should happen, though once an organization begins using a method for allocating particular types of costs, they should stay with it unless their operation changes significantly, in order to have “apples to apples” comparative reporting and financial statements.

Methods for Allocating Costs

Three commonly used methods for allocating costs are staff headcount, labor dollars, and square footage. Most organizations will use a mix of these methods, allocating things like physical plant expenses (rent, utilities, etc.) based on how the space is subdivided, and other costs based on the number of staff hours or labor dollars used by a particular category or program. However, especially in smaller organizations where space is shared and staff members wear many hats, it can get complicated, the square footage method may not apply at all, and using spreadsheets in conjunction with Quickbooks classes is extremely helpful. In almost all organizations large or small, a comprehensive time sheet system using either spreadsheets or a database is absolutely necessary for allocating staff hours or labor costs, as senior staff and administrative support personnel will perform duties which span multiple programs, even if other staff only work in a single, clearly defined area.

Ideally all costs would be allocated as they were incurred. However, this can result in high bookkeeping overhead. For example, the cost of worker’s compensation, unemployment insurance and employee benefits should be allocated based on how staff hours or labor costs are divided. But if those hours or costs vary from payroll to payroll, the related insurance and benefits allocations might best be done quarterly or annually.

If an organization has made staffing or programmatic changes, existing cost allocation methods should be reviewed. Under these circumstances a method which worked well in the past may now allocate a disproportionate share of costs to supporting activities or a specific program. Again, use of spreadsheets or a database to track staff time is essential to this process, since employee-related expenses usually represent the largest percentage of a nonprofit’s budget.