EricYPTC

Most nonprofit organizations have to allocate costs for one reason or another.  If done incorrectly, however, your allocations can impair the quality of your financial information and lead to ruinous decision-making.

Overhead and administrative costs typically need to be allocated to various programs and departments in an attempt to understand the true operating costs of these programs and departments.  This information is usually needed to report to funders.  Executive directors, board members, program managers, and department heads may also find this information helpful when reviewing internally generated financial reports.  It intuitively makes sense, for example, that a portion of the executive director’s salary should be allocated to the various programs even though the ED may not directly work in any of them.

The problem comes when the cost allocations have the unintended effect of obscuring performance. In serious cases the financial information produced by an organization’s accounting department can cause management to make erroneous decisions that may actually undermine their organization!

This is best illustrated with an example.

Presented below is a hypothetical nonprofit that provides afterschool services to children at two different sites.  Site 1 has 100 students, Site 2 has 200 students.

The school earns revenue of $100 per student per month through some combination of parent payments and government support.  The school incurs direct expenses of $80 per student for direct teacher salaries, supplies, and other direct expenses.  The school has certain fixed overhead and administrative costs which are needed to support the programs.  The school’s accountant has determined that $60,000 of these costs should be allocated: half to Site 1 and half to Site 2.  Based on this information, the school is able to produce the following budget:

      Per
Student
per Month         Site 1            Site 2           Total    

Students                                                     100                200                300

Revenue                           $100          $120,000     $240,000      $360,000

Direct costs                      $80             $96,000      $192,000      $288,000
Allocated overhead                             $30,000        $30,000        $60,000
Total costs                                           $126,000      $222,000      $348,000

Net                                                         ( $6,000)        $18,000         $12,000

The board treasurer, worried that Site 1 is expected to lose money, has suggested that it be closed reasoning that the $6,000 loss in Site 1 can be avoided and total net can be increased from $12,000 to $18,000.  Though this would mean serving 100 fewer students, the treasurer feels strongly that this will make the school more financially secure.

What do you think?

The executive director, worried that he/she may lose a third of their program, decides to call our firm, YPTC, to take a look at the numbers.  (Sorry for the shameless plug, but I am after all writing this for free on a Sunday afternoon.)  After analyzing the situation, we put together the following proforma which assumes Site 1 has been closed:

      Per
Student
per Month        Site 1            Site 2           Total    

Students                                                    0                       200                200

Revenue                           $100              $0                $240,000      $240,000

Direct costs                      $80               $0                 $192,000      $192,000
Allocated overhead                               $0                   $60,000        $60,000
Total costs                                              $0                 $252,000       $252,000

Net                                                           $0                 ($12,000)      ($12,000)

The analysis shows the surprising result that instead of producing a larger positive net, the organization’s finances actually get worse resulting in a loss of $12,000, a decrease of $24,000!

A moments examination of the numbers shows why.  While the direct revenue and all the direct costs of Site 1 went away, the fixed overhead did not.  The $30,000 of fixed overhead which had been charged to Site 1 had to go somewhere, and that somewhere in this example was for all of it to get charged to Site 2.  This produced a negative $30,000 swing for Site 2 taking it from a positive $18,000 net to a negative $12,000.

The financial reports of this organization obscured the fact, due to the cost allocations, that Site 1 had a positive contribution margin.  This means that after subtracting the direct costs from Site 1 revenue, Site 1 was contributing $24,000 to the bottom line.  If Site 1 were to close, not only would 100 fewer students be served, but the $24,000 positive contribution margin would be lost.

Moral of the story:  Cost allocations are a fact of life for most nonprofits.  Be careful, though, to perform the necessary financial analysis to understand your cost structure so that your financial reports do not lead you astray.

Comments welcome.

Eric Fraint, President and Founder
Your Part-Time Controller, LLC

There are a number of problems with nonprofit accounting rules.

When I say problems, I mean accounting rules that actually make it more difficult to read and understand a set of nonprofit financial reports.  If you have worked in the nonprofit world long enough, this statement should come as no surprise.

The biggest offender is the rule regarding the timing of revenue recognition with multi-year grants.  This rule says that if your nonprofit organization receives a multi-year grant award, and assuming there are no conditions attached to it, all the revenue is recognized in your financials in the first year.  The revenue may be broken down between restricted and unrestricted, but in total it is all recognized upfront.

This is best shown with an example.

Imagine your organization receives a letter from your favorite foundation awarding you a $300,000 grant to support your main program over the next three years (i.e. $100k per year).  There are no conditions attached to this grant.

Over the three-year term of the grant, your total revenue and expense associated with this grant will look like this:

                       Total      

Revenue      $300,000

Expense      $300,000

Net                            $0

So far, so good.  However, when we break this down year by year, we see the following:

                        Year 1        Year 2         Year 3           Total    
Revenue      $300,000                 $0                   $0     $300,000

Expense      $100,000     $100,000      $100,000     $300,000

Net               $200,000   ($100,000)   ($100,000)                 $0

Note that the totals in both tables above are the same.  However, in Year 1 it looks like the organization has a windfall profit of $200,000.  In years 2 and 3 it looks like the organization has a loss of $100,000 each year.  We know intuitively that the organization is getting $100,000 each year and is spending $100,000 each year, but that is not what the financial reports seem to be saying.

Multi-year grants such as this make it difficult for nonprofit boards and management to understand and interpret their results.  This is further complicated when we consider the impact of the restricted and unrestricted portions of these funds.  (The different types of restrictions will be discussed in a future blog.)

This accounting rule also creates difficulties when budgeting.  How do you prepare your budget for year 2 or year 3?  You will be receiving $100,000 in each of those years from the foundation, but if you put that in your budget, won’t you be double counting revenue that was already recorded in year 1?  But if you don’t include that money, then won’t your budget look like your program is running at a deficit when in fact it is not?

Let me know if you would like me to discuss some solutions to this dilemma in a future blog.

Moral of the story:  almost all nonprofit organizations share this frustration with the accounting rule pertaining to revenue recognition with multi-year grants.  The good news is that there are ways to deal with this when presenting financial information and when budgeting that make your information easier to understand.

Comments welcome.

Eric Fraint, President and Founder
Your Part-Time Controller, LLC