Functional Expense Classification

Functional expense classification is the practice of grouping an organization's expenses according to the purpose, or function, they serve rather than according to what was bought. It is used mainly by nonprofit organizations, which classify costs into program services, which carry out the organization's mission, and supporting services, the organization's administrative and fundraising costs, which are usually split between management and general activities and fundraising. Some membership organizations add a separate membership development category.

The other way to classify expenses is by their nature, also called natural classification: salaries, rent, travel, depreciation and so on. Under US GAAP for not-for-profit entities, as updated by the FASB in a standard effective from 2018, every nonprofit organization must present expenses by both function and nature, and must show the relationship between the two in one place. The same functional split appears in Part IX of the IRS Form 990 information return.

A food bank pays for warehouse staff, delivery trucks, an accountant and a team that runs donation drives. Looking at the bills by type, salaries, fuel, rent, tells you what the money bought. Looking at them by function tells you what the money was for: feeding people, keeping the organization running, or raising more money.

Donors and watchdogs care a great deal about the second view. They want to know how much of each dollar goes into the actual mission, and how much goes to overhead and to the cost of asking for donations.

• Program services. Activities that deliver the goods and services the organization exists to provide, such as running a shelter, funding research or operating a museum.
• Management and general. Oversight, business management, general record-keeping, budgeting, and governance activities such as board meetings, that support the whole organization rather than a specific program.
• Fundraising. Activities that persuade donors to give money, goods or time, including campaigns, events, grant applications and maintaining donor lists. These are often reported as fundraising expenses.
• Membership development. For organizations with members, the cost of soliciting new members and membership dues, where these are not primarily contributions.

Many costs serve more than one function and must be allocated on a reasonable and consistent basis. Salaries are often allocated using time records; occupancy costs by floor space; and depreciation by how each asset is used.

Suppose a charity pays total salaries of $400,000, and time studies show staff spend 70 percent on programs, 20 percent on management and 10 percent on fundraising. Salaries are reported as $280,000 program, $80,000 management and general, and $40,000 fundraising. Rent of $60,000, with 80 percent of space used for programs, adds $48,000 to programs and $12,000 to management and general. In the combined analysis, each natural expense line appears across the functional columns, and the column totals give total expenses by function.

Special rules apply to joint activities that combine fundraising with program or management purposes, such as a mailing that both educates the public and asks for donations. Costs may be allocated to programs only if the activity meets criteria for purpose, audience and content; otherwise the whole cost is treated as fundraising.

Functional reporting lets readers judge how resources are used. Many donors, grant makers and charity evaluators look at the share of expenses spent on program services, sometimes called the program ratio. Regulators use the Form 990 data to monitor tax-exempt organizations, and lenders and boards use it to judge efficiency.

The emphasis on low overhead has critics. Under-spending on systems, staff and fundraising can weaken an organization, and allocation methods can be manipulated to make programs look larger. The classification is therefore most useful alongside information about results, as well as the statement of activities showing the change in net assets. For comparison, a for-profit organization usually presents expenses by nature or by functions such as cost of sales and selling expenses, without the program and fundraising categories.

• Financial Accounting Standards Board
• IRS: About Form 990