Basic Financial Concepts

Nonprofits operate as businesses. You’re “in business” to make some sort of positive impact on the world, and you want to stay in business for as long as you can. So finances are of central concern to your organization’s survival. In order to best understand the impact of the federal regulations on your business, it helps to have a basic understanding of the following financial issues.

Revenue and Expense

You might say that a nonprofit is in the business of spending money. Beneficial impact is your essential mission, but spending money is how you accomplish that mission.

In order to spend money, you must have money (or at least the promise of it) to spend. So a nonprofit’s managers are always paying attention to the balance of revenue and expenses. Even though you’re not in business to make a profit, you can’t afford to lose money. You have to at least break even, or you’ll go out of business.

Where do nonprofits get the money they need? A few nonprofits are independently endowed; others are supported by a broad membership base; some others are subsidiaries of commercial business, using profit from the commercial parent to fund some of the nonprofit’s charitable activities. But most nonprofits—and even those with plenty of resources—rely heavily on grants for their basic revenue. And grants are often limited to reimbursement of actual, allowable expenses that the nonprofit incurs in the course of conducting specific projects/activities.

Cost Recovery

Because most grant revenue is restricted to reimbursement for actual, allowable expenses (i.e. costs), the concept of cost recovery is a fundamental driver in a nonprofit’s business model. Cost recovery simply means getting paid for (recovering) all the expenses you incur in accomplishing the funded project.

But what are "all the expenses you incur"? Most expenses related to an activity are obvious, but there are also organizational costs that contribute to the total cost of an activity: headquarters functions are the primary example. In order to understand the full cost of an activity, the nonprofit needs a plan for allocating expenses to final cost objectives and a sophisticated accounting system to record and report on those allocations. Further, the nonprofit must be able to satisfy the donor that they are reimbursing only those costs that they consider to be allowable under the terms of the award agreement.

Optimizing cost recovery from a grant requires managers to pay close attention to four key factors:

Allowability

The terms of the award agreement define the requirements that must be met for an expense to be reimbursed by the funder. Learn about the basic federal rules of allowability at Allowable Costs - basic principles.

Allocability

Understanding what costs are allocable to the final cost objective funded by the award enables the nonprofit to know the total cost of the activity. This includes costs that directly benefit the activity (direct costs) and costs that benefit it but may not be directly associated with it (indirect costs). Learn about the federal rules for determining the total cost of an activity at Cost Allocation Principles.

Documentation

Proper documentation is essential for assuring the funder that the expenses are allocable and allowable under the terms of the agreement. Learn about the federal requirements for documentation at Documentation Requirements.

Audit

The federal government wants third-party assurance that only allowable/allocable expenses are reimbursed. Learn about the requirements for audits of federal awards at Audit Basics.


Notes:
If you're not quite sure about the meanings of the terms cost, expense and cost objective as used on this site, it may be helpful to refer to my Primer on Costs, Expenses and Cost Objectives. You may also be interested in my brief discussion of revenue at About Revenue.

If your not trained as an accountant and you need some basic background on accounting principles and terminology, Nonprofit Accounting Basics and Accounting Coach are excellent resources for beginners. Check them out.

Also, a shout out to teacher Brooke and students Ally, Amanda, Stephanie & George for recommending Marysville University's Quintessential Accounting Resource Guide as yet another valuable resource for students of accounting.

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