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At a recent board meeting for Urban Harvest STL, one board member raised an interesting question, “What is the ideal percentage of the budget we should spend on salaries?” As with most questions like this, the answer is - It depends. In particular, it depends on the operating requirements and strategy of the organization. Some organizations are more labor intensive, while others may be more volunteer driven. For example, the American National Red Cross – Blood Regions are highly labor intensive, depending heavily on employing skilled nurses and other medical professionals to conduct their blood bank operations. They spend a substantially larger portion of their budget on salaries than an organization like Junior Achievement, which fulfills its mission primarily through volunteers. So, these two organizations would be expected to spend a different percentage of their operating budget on salaries and wages as a result of their service model.

More importantly, salaries should be market competitive with the skills required. For many nonprofits, the issue is not about paying too much, but rather with paying too little. This, in turn, results in increased turnover, leading to higher recruiting costs and potential disruptions of services. To help with this GuideStar, an information service that tracks reporting on over 2,000,000 United States nonprofit organizations, has a mission to advance transparency, enable users to make better decisions, and encourage charitable giving. Their GuideStar Nonprofit Compensation Report reviews key employee compensation based on the organization’s size at some 96,000 charitable nonprofit organizations and is available through their website at www.guidestar.org. Armed with this information organizations can better determine the appropriate salary levels for their organization.

Another important question for nonprofits to ask is how their expenditures are divided into the functional expense classifications: program, fundraising, and management and general expenses. Functional expense classifications help explain why the expense was incurred rather than what the expense is. As per the IRS tax filing (form 990), most tax-exempt organizations that are 501(c)(3) entities are required to categorize their expenditures into these three functional expense classifications. Likewise, with the implementation of ASU 2016-14 in calendar year 2018, all nonprofit organizations are required to present an analysis of expenses by their functional expense classification either in the statement of activities or in the notes to the financial statements. Donors, creditors and other supporters use this information to assess an organization’s operating efficiency and resource utilization.

Program expenses are costs related to providing the nonprofit organization’s programs or services in fulfillment of its mission. These are the direct and indirect costs related to activities that result in goods and services being distributed to beneficiaries, customers, or members. This should comprise the bulk of the expenditures for the organization. Salaries and wages for staff providing direct services and their direct supervisors would be expensed under this classification. This would also include salaries of those who determine the eligibility of clients for program services.

Fundraising expenses are the costs of all activities related to an appeal for financial support for the organization including contributions of money, securities, time, materials, or facilities. This includes the costs of holding a fundraising event, solicitation of contributions, and salaries of those individuals involved in the fundraising process. Also, included in fundraising expenses are the salaries of fund development and grant writing staff and staff involved in soliciting donors and volunteers.

Management and general expenses are costs related to operating the organization and are best defined by what they are not - expenses that are not directly related to providing services or fundraising. This includes such things as business management, finance, general recordkeeping, budgeting, and accounting. Typically the majority of the salaries of the executive director and chief financial officer are charged to management and general expenses because their activities relate to the overall benefit of the organization and not to just one program or area of the organization.

Often times, smaller organizations have employees who split their time amongst various activities, thereby their work may be in different functional expense areas. For example, the executive director may be directly engaged in providing services, while also actively involved in the fundraising process. In this case, the cost of executive director’s salary must be allocated to the various functional expense classifications.

There are two options for allocating the costs: the direct method and the indirect method. The direct method would require charging the actual hours spent in each different activity to the appropriate functional expense classification. For example, if on a given day the executive director spent 4 hours on program services, 2 hours fundraising and 2 hours preparing a board presentation, the costs would be directly charged to the functional expense based on the hours worked in each. The indirect method relies on a standard allocation of the executive director’s time, generally based on a time study over a given period, such as a week or a month. Either method is acceptable for tax and financial reporting purposes.

Most large donors look at the percentage of expenditures in each of the functional expenses in making their funding decisions. Ideally, an organization should keep administrative and fundraising costs as low as possible, with the bulk of expenditures occurring in the program classification. Many nonprofits who are successful at this will highlight it in their marketing materials. They show how much of every dollar raised goes to fulfilling their mission - this is the program costs divided by total costs. The higher the ratio, the more efficient the organization is perceived to be. However, the smaller the organization the more likely administrative costs will be a larger percentage since many of these costs are fixed and don’t scale or scale as rapidly as the size of the organization increases. One of the best performing organizations I’ve been involved, Child Day Care Association of St. Louis kept their management and general expenses under 5 percent and their fundraising expenses under 2 percent of total expenses.

So an organization facing the dilemma of how much of their budget should go towards salaries should first consider the required skill level to fulfill the organization’s mission and allocate sufficient funds to pay competitive salaries. GuideStar and other information services provide market data on pay rates for various positions and skill sets that can be used to determine what would be competitive. All organizations should ensure that their wages are charged to the proper functional expense classification.

And, if some staff is performing tasks in multiple functional expense classifications, they can allocate their time directly or by using an estimate of their time in each of the functional expense classifications. The overall goal of the organization should be to lower its fundraising, and management and general costs relative to program costs to demonstrate their operational efficiency and to be more attractive to donor organizations.