Nonprofit Expense Categories: Guide + Examples

As a nonprofit leader, you've likely seen organizations struggling with delayed grants, flagged audits, or loss of funders because of unclear expense reporting. 

The struggles don't have to hit your organization. With clear expense classification, you can ensure better compliance, financial transparency, and improved budgeting. 

In today's guide, we'll discuss various nonprofit expense categories, why they are important, and some best practices for classifying your organization's expenses accurately. 

We'll also review a sample statement of functional expenses to gain further insight and identify the best tools to enhance your expense categorization.

TL;DR - Nonprofit Expense Categories

Let's get started with a quick overview of the three main functional areas for categorizing expenses for nonprofit organizations:

1.  Program Expenses 
2. Administrative Expenses (Management and General Expenses)
3. Fundraising Expenses 

We’ll explore these three nonprofit functional expense categories in greater detail in one of the upcoming sections. 

While other organizations struggle with expense allocation, your best bet for mastering the process is to use modern financial tools to simplify it. 

Accounting tools and dedicated nonprofit financial management software can help you automate expense management, ensuring consistency and accuracy. 

For example, you can use Martus, our specialized financial management software, to extract expense, income, and other data from your accounting tool for accurate expense management, budgeting, reporting, and even forecasting. 

Book a consultative call with our team to discover how Martus can transform the way you manage expenses and other budget categories. 

Why Accurate Expense Categorization Matters

When you miscategorize expenses, the ripple effects can be devastating. You can find yourself struggling with reporting inaccuracy, loss of donor trust, and even litigation.

Proper categorization matters for several reasons.

1. Prevents Broken Reporting

With accurate classification, your financial reports reflect reality and become reliable tools for proper decision-making. 

Accurate categorization helps:

• Reduce Manual Work and Errors: Tools with built-in expense tagging help eliminate the inefficiencies and inconsistencies associated with manual spreadsheets and outdated legacy systems. 

• Strengthen Reporting: Accurate categories ensure your reports are accurate, consistent, timely, and actionable. 

• Improve Financial Visibility: By categorizing expenses by program, fundraising, and administrative functions, your board is able to see how you allocate resources and where you might need to adjust. 

• Support Strategic Planning: Clean categories ensure that your board can trust your performance metrics, such as cost per beneficiary and program efficiency ratios, allowing your organization to prioritize resources more effectively. 

2. Promotes Grant Approvals

Accurate categorization aligns your expenses with grant terms, which helps you match actual spending to grant-specific budgets and secure the trust of your grantors. 

The practice also simplifies grant reporting. When you track expenses accurately from the beginning, you reduce the time you spend reconciling documentation or explaining inconsistencies in financial reports. 

Proper categorization shows grantors that you are financially responsible and grant-compliant, increasing the chances of not only quicker grant approvals but also potentially increased funding. 

3. Protects Your Nonprofit Status

Correct expense categorization helps protect your 501(c)(3) status for tax exemption because you follow the expense regulations and financial reporting requirements set by the Internal Revenue Service (IRS). 

For example, you’ll be able to demonstrate that you spend reasonable amounts on administrative and fundraising needs, ensuring that the majority of your nonprofit's finances are allocated to mission-related programs. 

Accurate classification also simplifies annual filing and reduces the risk of audits and noncompliance penalties, which could include losing your tax-exempt status. 

IRS Rules for Nonprofit Expenses

Speaking of protecting your nonprofit status, the IRS has specific rules for how you should manage and report your expenses to ensure you act per the applicable nonprofit tax exemptions and use funds appropriately. 

The main IRS regulations for nonprofit organization expenses include:

• Form 990 Functional Expenses Categorization: The IRS requires you to categorize expenses on Form 990 into three main areas. These include program costs, management and general expenses, and fundraising costs.

• Mission-Driven Expenditure: Your program expenses must directly support your organization’s mission, based on the exempt purpose for which you acquired your 501(c)(3) status.

• No Private Benefit or Inurement: You are not allowed to use your organization’s funds and assets for private inurement or benefit to individuals such as the board members, shareholders, employees, or their families. Your focus must remain on charitable purposes. 

• Reasonable Compensation: Staff compensation, including salaries and liability insurance premiums, is an allowable expense for nonprofit organisations, provided it is at a reasonably fair market value to avoid private benefit issues. 

• Budget Allocations: When allocating resources in your budget, program expenses should significantly exceed administrative and fundraising costs to show that you focus more on charity. 

• Record-keeping: You must maintain detailed records of your expenses and other nonprofit budget categories as reported on Form 990 and any other tax returns you may be required to file. You should also keep these documents readily available for IRS inspection in case of an audit. However, even if you file Form 990-N or file no return, you must keep all records of your expenses and revenues. 

Failure to adhere to these rules and requirements can lead to losing your tax-exempt status, penalties, and even legal action. 

3 Core Nonprofit Expense Categories

Let's now look at the three main nonprofit expense categories in greater detail. 

1. Program Expenses 

Nonprofit program expenses are the costs directly related to furthering and achieving the mission of the organization. 

Some everyday program expenses include:

• Staff salaries for employees who run programs.

• Direct travel expenses for staff to get to program-related locations and events.

• Supplies and materials expenses for the ongoing items you need to run your programs, such as educational materials, medical supplies, and food for meals. 

• Contracted service payments for external service providers helping with your programs.

• Direct service costs incurred when providing a service, such as educating underprivileged children.

• Program-specific technology costs for tools, equipment, software, or other technology you use to deliver your program, such as nonprofit expense management software and case management software.

Program expenses have the following implications:

• Donor Trust and Public Perception: Funders, the government, and the public see that your organization is mission-focused if your program costs are high. It means that you are spending most of your funds directly on services and programs that meet your purpose. This usually boosts donor or public confidence and attracts more support. 

• Grant Eligibility and Ratings: A higher proportion of program expenses can make your organization more competitive for grants, as your ratings will be more favourable when considered by charity watchdogs and foundations. 

2. Administrative Expenses (Management and General Expenses) 

Also called management and general expenses, the administrative costs of nonprofit organizations are the direct daily costs of operating the organization. They are the nonprofit operating expenses that aren't tied to fundraising or programs. 

Some common administrative expenses include:

• Direct overhead costs or facility expenses for running the organization, such as leases, rent, mortgage payments, debt financing and interest payments, and utilities (water, electricity, and gas).

• Administration technology (general office technology for daily operations, but not specific to program delivery), such as IT support software, phones, and computers. 

• Professional services fees related to legal counsel, bookkeeping, auditing, and accounting for charitable organizations.

• Administration personnel costs, such as salaries for staff members involved in your organization's general operations, including the executive director, finance team, human resources department, and public relations team. 

• Board expenses, such as travel and accommodation for members to attend meetings. 

• Subscription and membership fees for relevant publications you subscribe to or professional organizations you join. 

• Training and development expenses for professional capacity building for staff and volunteers. 

• Insurance and risk management costs for the coverage you need to protect the entire organization, such as property insurance. 

Here are some implications to expect regarding administrative expenses:

• Operational Efficiency and Capacity Building: Even though high administrative costs often have negative connotations, they usually show that you've invested in proper infrastructure, governance, training, and compliance. These investments are important for long-term sustainability and operational effectiveness. 
• Risk of Funder Misinterpretation: Excessive administrative costs can be a red flag to funders, as they may infer inefficiency or mismanagement. This could damage your reputation and income streams if you don't communicate the situation appropriately. 

3. Fundraising Expenses 

Nonprofit fundraising expenses are the costs associated with initiatives that generate revenue. They can include:

• Event costs, such as dinner or catering, venue rental, and entertainment. 

• Fundraising technology costs for the tools and platforms you use to manage campaigns and donations, such as donor management software. 

• Marketing and advertising expenses for promoting your fundraisers, such as flyers, social media ads, and email campaigns. 

• Grant acquisition and management costs for staff time spent writing grant applications, grant consultant fees, grant-specific research expenses, and dedicated grant reporting resources. 

You can expect fundraising expenses for nonprofit organizations to have implications such as:

• Sustainability of Revenue Streams: You need to cover fundraising costs to grow and sustain revenue. They enable you to acquire and retain donors, plan and execute fundraising events, and secure your organization’s long-term viability. 

• Scrutiny and Accountability: If your fundraising expenses are high and the corresponding returns are low, you may get concerns regarding how you allocate resources. Transparency and demonstrating a return on investment in fundraising are crucial for maintaining the trust of donors and other stakeholders. 

How to Classify Expenses in Your Nonprofit Budget

Accurately classifying expenses in your budget promotes transparency, compliance, and strategic planning. Here's a step-by-step framework to help you accurately and consistently classify expenses. 

1. Understand the Categories: Study and understand the three core nonprofit expense categories, as well as the common types of items that fall under each. 
2. Select a Classification Method: You can use the percentage of use method, which allocates shared expenses based on the estimated percentage used by each function. For example, you can split rent as 50% program, 40% administrative, and 10% fundraising costs.
   
   Alternatively, use the time-tracking method, which uses project tracking or timesheets to allocate certain expenses, such as salaries and benefits. For example, you can track the time a staff member spends working across multiple categories. 
3. Use Expense Allocation Tools: Nonprofit accounting software like Sage Intacct and NetSuite can help you through project or class tracking features. You can also use a nonprofit chart of accounts that aligns with your functional expense categories. A standardized allocation template is also helpful for staff to follow. 
4. Document All Policies: Create written policies that outline how each expense type should be allocated and provide the rationale behind it. For example, a 50/30/20 basis depending on the outcomes of the previous years. Have your teams apply this policy across all departments and fiscal periods. 
5. Train and Communicate: Train your staff across all departments on how to accurately classify expenses and why proper classification is essential. 
6. Review and Refine Regularly: Conduct monthly, quarterly, semiannual, or annual reviews to validate allocations and classifications, ensuring accuracy and consistency. Adjust as needed based on actual spending or time, particularly if you have significant changes, such as when a program expands or staff roles shift substantially. 

You'll want to ensure consistency across the departments to maintain or improve forecasting accuracy. Clear and consistent classification helps you analyze past trends and predict future needs more effectively. 

Statement of Functional Expenses Example

The nonprofit statement of functional expenses is an accounting document showing how you distribute expenses between your organization’s functions. 

Stakeholders use the statement to assess how you allocate costs related to administrative duties, programs, and fundraising activities. 

It helps ensure accountability and evaluate proper financial stewardship. 

Here's a sample statement of functional expenses for a nonprofit:

The statement of functional expenses is specific to nonprofits and is important for audits and board reporting. 

Auditors use it to assess your organization’s financial health, operational efficiency, and compliance with GAAP (Generally Accepted Accounting Principles) and IRS Form 990 filing. 

The statement helps the board see how you allocate your resources, showing accountability and transparency. The board is able to understand your financial health and how effectively you are achieving your mission. 

Best Practices for Nonprofit Expense Categorization

Implementing standardized systems and tools helps ensure consistency across departments’ reporting periods. Here are some best practices to emulate when classifying expenses. 

1. Set up a Standardized Chart of Accounts: A well-defined nonprofit chart of accounts (COA) sets the basis for accurate expense tracking. Your COA should include detailed categories and subcategories that align with your fundraising, administrative, and program activities. Ensure you follow GAAP and Form 990 requirements. Keep the COA flexible but consistent and free from duplications or overlaps to reduce errors and simplify reporting. 
2. Use Budgeting Software: Invest in robust nonprofit budgeting software to streamline expense tracking, analysis, and reporting. Tools like Sage Intacct and QuickBooks use class tracking, project coding, or cost centers to associate expenses with the correct category. They can also automate expense allocation to save time and reduce manual errors. 
3. Train Program and Department Staff: Train your program and department staff on how to categorize expenses and how the practice affects your financial health. Ensure they use the same terms and definitions to avoid confusion and ensure consistent reporting. You can make simple cheat sheets or guides to clarify how to classify common types of expenses. 

In addition to these measures, nonprofit-specific financial management software can improve accuracy and consistency in expense categorization. 

For example, Martus offers pre-built templates for budgeting and classification, which align with nonprofit best practices. 

Martus allows you to create Special Purpose Worksheet Templates, a type of our Special Purpose Worksheets (SPWs). 

SPWs allow you to record assumptions and predefine certain budget amounts. The templates combine assumptions and calculations that end-users can use within individual budget worksheets, which include expenses. 

Martus also features automation capabilities that enable you to extract data from your accounting platform, thereby reducing the risk of inconsistencies between budgeting and actuals. 

Request a personalized demo to see how Martus can transform how you manage your finances. 

Frequently Asked Questions (FAQs)

We'll close the guide with answers to common questions about nonprofit expense categories. 

Do Small Nonprofits Need to Follow Expense Categories?

Like larger nonprofits, small nonprofits also need to follow expense categories to maintain legal compliance and ensure transparent financial reporting. 

As a small organization, you'll be able to understand your spending patterns, identify areas for potential cost savings, and make data-driven decisions on how you allocate your resources. 

Can a Single Expense Be Split Between Multiple Categories?

You can split a single nonprofit expense between multiple categories if it benefits more than one function or program. 

For instance, if your executive director splits their time 50% on overall management, 35% on programs, and 15% on soliciting funds, you can allocate their cost accordingly based on these percentages. 

What Tools Can Help with Nonprofit Expense Categorization?

Tools and accounting software like Sage Intacct, expense management software, and dedicated nonprofit financial stewardship software can help you categorize expenses correctly. 

For example, Martus integrates with your accounting software to automatically pull budgeting data, ensuring consistency across all expense categories. 

Conclusion

Through better expense categorization, you can enjoy better strategic planning, increased donor trust, and improved audit readiness. 

But it comes at a price. If you use outdated tools, you'll pay more in terms of time and incur costly mistakes due to manual data entry errors. 

Classifying your expenses properly requires investing in modern tools that offer expense management solutions, such as class tracking or cost centers. 

Specialized nonprofit financial governance tools that link with your accounting platform can also help streamline the entire process. 

For instance, here's how Martus can help:

• Pull data from your accounting software to keep everything updated in real time.
• Make unlimited budgets automatically based on different categories. 
• Forecast budgets, including expenses. 
• Generate financial reports for the board and the IRS. 
• Maintain lock controls for approved workflows or worksheets to prevent accidental end-user changes. 

Streamline expense management and make smarter allocation decisions with Martus.