By Steve Zimmerman
It is a story as old as time. A donor expresses interest in a nonprofit’s programs, seeing the true benefits of the efforts to strengthen their community. “How much does the program cost?” the donor asks, on the verge of donating. “We can do all this for $1,000 per kid,” the Executive Director excitedly exclaims. The donor, in awe of the impact and efficiency, makes a donation and both donor and staff leave the interaction feeling valued and excited about the organization’s work.
The only thing wrong with the story is that the actual cost of delivering impact is more than $1,000. As the organization continues to deliver on its mission it works harder to raise more money, but never captures the value it is bringing to the community and continually feels like it has a hole in its budget. This is because it didn’t do the math necessary to calculate the true cost of the organization’s impact.
Knowing the true costs of impact is essential for financial sustainability, and it begins with perhaps the most tedious aspect of accounting, coding expenses. There are three types of expenses that make up the true cost of a program: program specific costs, shared costs and administrative costs. To understand true costs, we must first identify these expenses.
Program specific costs are the easiest to identify as they directly relate to the program being delivered. Sometimes called direct expenses, they include program staff time, client assistance, or any other expense that you know relates to a specific program. These expenses are usually budgeted for in a program budget and are overseen by the program manager. The easiest way to identify a program specific cost is to look at an invoice or a staff position and ask, “Can I tell which singular program this is for?” If the answer is yes, then it is a program specific cost.
If the answer to the question above is “no,” it may be a shared cost.
Shared costs, also sometimes called common costs, are expenses which benefit multiple programs. These include occupancy related expenses – assuming that multiple programs are conducted out of one building – as well as technology related expenses. Shared costs are split between programs through a cost allocation process. Don’t let the name scare you like ghosts at Halloween. Rather, it means you find a meaningful method to determine what percentage goes to each program. Often the expenses are split by either the percentage of total employees who work in a program or by the square footage a program occupies in a building. These expenses may feel like administrative expenses or overhead, but accounting rules allow them to be split directly into programs.
The last component of true costs is administrative expenses. Administrative expenses are those costs which help to keep the organization’s corporate structure legal, including time and expenses associated with the Board of Directors, legal services and accounting. One common mistake nonprofits make is putting too many expenses (such as rent and technology) into administration. Expenses that are directly related to programs or are used by programs may be charged either directly to the program or allocated to programs using the shared cost allocation. This is important since administrative expenses are a key component of overhead, and miscoding may incorrectly raise your overhead percentage – a key, if misguided, ratio looked at by donors.
Administrative expenses are tracked separately in an organization’s accounting system for reporting on financial statements and the IRS Form 990. However, to determine the true cost of a program, a portion of them needs to be added to the program specific costs and the shared costs for an individual program. Just as administrative expenses are included in the price Apple sets for an iPhone, nonprofits need to include administrative expenses when determining what it costs to educate a youth, provide a meal, put on a theater show, or house an older adult. Administrative costs can be split in many ways, though we typically see them split by a program’s percentage of direct expenses (direct expenses/(total expenses-administrative expenses)).
For most organizations, personnel expenses are the largest portion of their budget, typically making up close to 80% of total expenses. Therefore, in determining the true costs, it is best to begin by identifying where staff are spending their time. Leadership positions like the Executive Director or a Program Director will find this difficult as they split time between multiple programs. However, at least having an estimate of where people are spending time is essential for determining true costs. Wade through the difficulty of splitting time knowing you can always adjust later. Note that your guide should not be in which programs people are funded, but rather where are they actually spending time.
Unfortunately, many organizations don’t calculate the true costs of their programs. There are a number of reasons for this, including:
- Donors are not asking for it: True, donors might not come out and specifically ask for the true cost of a program, but they indirectly are curious about it if they want to contribute to the organization’s impact. Calculating the true cost allows an organization to make sure it can financially deliver what it is programmatically promising a donor.
- Easy to get lost in the jargon: Try as I did, even this article contains a fair amount of jargon. In accounting, like any profession, it is easy to get lost in the jargon. Leadership should work with their finance staff or board treasurer to make sure they understand. Finance staff should try to explain the concepts in multiple ways. While it might be nice to understand how expenses are split, the most important part is understanding which bucket (specific, shared or administrative) to code them to.
- It is subjective: Accounting has the reputation of being objective since everything has to balance in the end. But far from being black and white, accounting is about navigating shades of gray. Yes, coding can be subjective. Don’t let the subjectivity make you feel like you’re doing something wrong.
- Are the numbers accurate?: All of these assumptions may make it seem like the numbers are not accurate. Think of true costs as more of an impressionistic painting rather than a photograph. No one is auditing the true costs calculation, but having an idea will be helpful in fund development and building the financial strength of the organization.
- Beyond the accounting system: Sometimes the barrier to determining true costs comes from the finance staff themselves, as it often requires a step beyond the accounting system. Finance staff like to print up reports already within the accounting system, but allocating administrative expenses often requires some manipulation in Excel. The benefit comes in how leadership will use the data.
Despite the list of barriers, the advantages of understanding programmatic true costs are plentiful. Most importantly, it allows the organization to tie its financial cost to the impact the organization is having in the community.
True program costs present the expenses associated with impact, but not the value these efforts bring to the community. Nonprofit organizations continually provide amazing, efficient impact. They should take pride in how they operate and not be ashamed of the financial costs required. Understanding the true costs of impact is the first step in this process and a means to invite others to contribute to increasing the impact even further.