Functional Expenses Decreased During Covid-19? How to Prepare for Conversations with Funders

The topic of functional expenses has garnered attention at nonprofit board meetings over the past year.

Many nonprofits feel pressure from foundation and government funding sources to maintain a certain level of program expenses as a percentage of total expenses (for example, greater than 75%). This metric has always been a matter of debate. Nonprofits also face criticism for not keeping enough cash in reserves.

But I’ve noticed an interesting trend with my clients over the past pandemic year: Many organizations have cut program spending and put more money into savings. This is generally a good thing—the pandemic was a wakeup call for many nonprofits about being financially prepared for a major disruption.

However, the indirect effect of saving more and spending less has been to lower the program expense percentage as a total, since nonprofits have had to maintain their infrastructure/admin and fundraising spending levels to remain viable. It’s important to be open and honest in communications with funders. Nonprofits should make sure they’re well-positioned to articulate why the metrics may have changed.

The Functional Expense Reporting Model

Nonprofit organizations have become accustomed to very stringent requirements governing how they report their expenses. Both the IRS and FASB (the people who set generally accepted accounting principles, known as GAAP, for nonprofits) require that nonprofits present their expenses by the following:

• Natural category such as salaries, rent, etc.
• Function such as program services, management and general (M&G), fundraising, etc.

The presentation of functional expenses is included in a nonprofit’s annual audited financial statements as well as its IRS Form 990.

The idea behind this functional expense reporting model is that nonprofits should spend the vast majority of their funds on direct services to their constituents, without spending too much on back-office functions. In this respect, organizations that spend very little on M&G and fundraising are often seen as efficient. Certain funding sources are known to evaluate nonprofit grantees based on what percentage of expenses fall into the program services category.

The Flaws, the Effects, and the Controversy

While these concerns by some donors are understandable at face value, the reporting requirements and the underlying philosophy are somewhat controversial within the nonprofit sector. The critics of the functional expense reporting model are eager to point out its flaws, arguing that the model amounts to a quick and dirty way of evaluating nonprofits. Chief among their concerns is the devaluation of infrastructure. To be effective, nonprofits need to invest in things like information technology, talent recruitment, program evaluation, and strategic planning. Nonprofits undertake these supporting services to enhance the effectiveness and efficiency of programs and to promote the long-term sustainability of their organizations.

However, since many such activities do not constitute the direct conduct or direct supervision of specific program services, they are presented under the M&G column of the statement of functional expenses, thereby raising the eyebrows of some donors by decreasing the overall percentage of expenses that fall within the program services category. In some situations, this model may even reward a nonprofit for poor financial management. For example, a nonprofit running a soup kitchen may inadvertently increase its program expense percentage by overpaying for food. Lastly, critics argue that the functional expense reporting model puts pressure on nonprofits to engage in aggressive accounting practices by potentially misclassifying non-program expenses within program services. (For a more thorough discussion of these concerns, I recommend reading Stanford Social Innovation’s seminal article on the topic).

Communication is Key

While functional expense reporting is nothing new, the Covid-19 pandemic added a new twist to the discussion. With shelter-in-place orders in March 2020, many nonprofits had to scramble to sustain their activities in the face of significant financial uncertainty. Organizations that relied on in-person activities faced immediate and drastic cuts to revenue. This presented an existential threat, especially for those organizations that had not maintained a healthy level of cash reserves. The pandemic has been a wake-up call for many nonprofits about being financially prepared for a major disruption.

In light of this, an interesting trend emerged. Many organizations curtailed spending to building up the balances of savings accounts. Since nonprofits typically spend most of their budget on program activities, the cuts disproportionately affected spending on program services. It is also more difficult to cut fundraising efforts and other infrastructure spending when trying to secure new revenue, and when planning, strategizing, and financial management are more critical than ever.  While building up savings is generally considered a good thing, the indirect effect of saving more and spending less has been to lower the program expense percentage as a total. Some nonprofits have expressed concern about what this may mean when soliciting grants from certain foundations or government agencies that may be particularly enchanted by the functional expense reporting model.

Nonprofits who find themselves in this situation should remember a few key points:

1. Not all funding sources evaluate their grantees based on functional expenses, so the dynamics discussed above may not present an issue for your organization.
2. The funders who do emphasize the importance of the program expense percentage most likely understand that the past year and a half has been anything but normal for most nonprofits. As a result, they should be more flexible and understanding if you are not hitting the number they like to see.
3. For grant writers and other fundraising professionals, it is important to understand whether this is an issue for any of your funding sources. If so, discuss your concerns with your organization’s accounting staff. While your funders will likely be more understanding due to the pandemic, you may find it helpful to have a well-articulated explanation prepared if the topic of functional expenses comes up in conversations with them.

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