The Functional Approach to Budgeting for Expenses

This piece is Part 4 of 4 in our Budget Building Essentials Series.

Often, we refer to the size of a nonprofit organization by the total expenses within its annual operating budget. This emphasizes the important role of expenses in the budget while also serving as a measure of an organization’s capacity to provide programs and services. To get the best possible budget for expenses, nonprofits should use a functional (programmatic) approach that better displays the cost of programs, activities, and operations and encourages staff ownership and accountability.

A thoughtful and effective expense budget will establish a benchmark for fulfilling an organization’s mission and convey the organization’s aspirations to delivery on its value proposition. To this end, it is best to build out the budget for expenses in a functional (department or cost center) format. This format will paint a clearer picture of the resources needed for programs, activities, and operations (including overhead expenses and fundraising).

It is also important to note that the functional presentation of expenses is required by generally accepted accounting principles (GAAP) for nonprofit organization financial statements and is also present on page 10, Part IX of the IRS Form 990 (Statement of Functional Expenses), which is required for 501(c)(3) and 501(c)(4) organizations and optional for other Form 990 filers.

For these reasons, along with others detailed below, it is best to assemble the expense budget functionally based on programs (a few typical examples could include senior housing, workforce development, conferences, and training programs) and operations covering departments such as membership, fundraising, and general and administration (G&A).  

Another benefit of assembling a functional expense budget by programs, activities, and operations is that it will encourage staff to take a higher level of ownership of the annual budget. By assigning budget assembly duties to the individual program managers, department heads, and staff who are directly responsible for managing and carrying out these functions, they will be more actively engaged in the budget building process and monitoring performance of future results. This will prompt staff to consider longer-term planning and explore how they could better optimize and align programs and activities to be more efficient, meet program objectives, and align with constituent needs and funder aspirations.

A functional expense budget will also help facilitate return on investment (ROI) analysis comparing the full cost of a program or activity with available funding and the expected results to be realized.

In comparison, a line-item expense budget that only details expenses by expenditure categories such as occupancy, professional fees, travel, printing, and insurance, will not provide enough information to assess costs related to fulfilling mission and meeting program and operational goals.

The one exception to this approach, which I always recommend, is preparing a separate labor expense budget early in the process, covering salaries and related employee benefits and payroll taxes. For most nonprofit organizations, labor will be the largest expense line-item and a primary consideration impacting an organization’s capacity to fulfill programs, provide services, and manage operations safely and effectively.

Planning Tip – The best time to adjust a nonprofit organization’s chart of accounts (COA) is just before assembling the next year’s annual budget. This timing allows management and staff to (1) assess what is working and not working with the current COA, (2) consider changes to the current COA to meet changing circumstances (such as evolving funding conditions and the addition of new programs and special events), and (3) reposition departments and cost centers to enhance financial communications and messaging and make financial reports easier to read and understand. The budget for the next fiscal year would be built within the format of the new COA. The current fiscal year would continue to operate under the old COA through year-end. This avoids mid-year COA changes and provides a clean starting format for the next fiscal year.

A functional expense budget will also help the Board, finance committee, and other volunteer leadership to view the budget with a focus on the strategic plan, mission fulfillment, and delivery on the organization’s value proposition. In contrast, a line-item budget will often direct the Board’s focus away from strategic considerations to micro-management of issues related to travel, occupancy, insurance, personnel, information technology, professional fees, etc. that are better left to senior management and staff.