Warning: Allocating Costs Can Be Dangerous To The Health Of Your Organization!

27 Jan

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 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 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

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