Understanding Functional Expenses for Nonprofits

It’s a straightforward concept. But, because most for-profit companies don’t track functional expenses, they’re just not familiar with it.

But it is need-to-know-information in the nonprofit world. Because you’re required to report functional expenses to complete your IRS 990 and maintain nonprofit status.

In this article, we’ll break it all down to show you what functional expenses are, why they matter, and how to track them in your organization.

What are Functional Expenses?

Functional expense reporting is the process of tracking the money you spend according to what the money was used for– like fundraising, administration, or programs.

“Functional expenses” aren’t a specific type of expense. Rather, it’s a way of looking at how you spent your money, according to the function that money accomplished.

For example, “salary” is a straightforward line-item on a for-profit financial report. 

But a nonprofit must track what “function” that salary was used to support. But what is a function, anyway?

There are 3 core functional expense categories:. 

To complete your IRS 990, you’ll need to report your expenses based on how they fall within 3 categories, they are: 

• Program Services – This includes any costs associated with executing programs and services to fulfill your officially declared mission. This may include materials, advertising, salary of program administrators, a portion of your rent, and more.
• Management and General Administration – This category includes most of what you’d call “overhead costs.”  Here you’ll put operational expenses that aren’t involved in executing your mission or fundraising. For example, office rent, executive salaries, utilities, and office supplies will probably fit into this category.
• Fundraising – Here, you’ll put costs directly tied to raising money. That may include special event costs, advertising, staff salaries, and more. 

These 3 expense categories are mandatory for the IRS, but you may choose to track others internally.

Many of your expenses (like salary, rent, and utilities) contribute directly to the execution of multiple functions. So for those categories, you’ll need to allocate your expenses according to how much they contribute to each function, which we’ll discuss a little further down the page.

Functional expenses versus natural expenses 

We’re here to talk about functional expenses, but the Statement of Functional Expenses actually shows 2 types of expenses– functional and natural. So, what’s the difference?.

First of all, to be clear, your organization only has ONE set of expenses. 

Functional and natural expenses are the same expenses; they’re just 2 different ways of looking at how you spent your money:

• Functional expenses: Categorizes your business expenses by the “function” those funds were used for, like programming, administration, or fundraising.

• Natural expenses: Categorizes your business expenses based on the “nature” of those expenses– like salary, rent, utilities, maintenance, supplies, and so on. 

Many people are comfortable with natural expenses because most for-profit businesses classify their expenses ONLY by nature. 

But non-profits need to classify their expenses according to both nature and function.

A simple example of functional expense allocation:

Let’s say you rent a 20,000 square foot building for your nonprofit, which runs after-school programs in a disadvantaged neighborhood.

Approximately 3,000 square feet of space is used for administration. And the balance (17,000 sqft) is used as classroom space to execute your programs. of rent to the administration function. 

15% of your space (3,000/20,000) is used for admin, so you’d allocate 15% of your rent to general administration expenses. And the other 85% of your rent would be allocated to program expenses, as in the example above.

Why do you need to track functional expenses?

So why do nonprofits track functional expenses? There are 3 simple reasons:

1. It’s the law. You need to include a functional expense report with your IRS 990. And if you don’t file a 990 for 3 consecutive years then you automatically lose your tax-exempt status. So you really don’t have a choice, but if you want more reasons…
2. To pass an independent audit. Reporting functional expenses has been required by Generally Accepted Accounting Principles (GAAP) since 2017, as detailed in ASU 2016-14. That means you’ll need to present a Functional Expense Report to pass an audit.
3. To build public trust. Funders, donors, charity watchdog organizations, and others want to see how you’re spending your money. Being clear, consistent, and accountable in your reporting of expenses is a big step toward earning their trust.